IMF POLICY PAPERFeb 04, 2013 · Staff proposes that the indicative medium-term target for...

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IMF POLICY PAPER

REVIEW OF THE ADEQUACY OF THE FUND’S

PRECAUTIONARY BALANCES

EXECUTIVE SUMMARY

This paper reviews the adequacy of the Fund’s precautionary balances, using the framework approved by the Board in 2010. The review takes place on a standard two year cycle. The paper discusses developments since the last review in 2012 and revisits several issues relating to the assessment of reserve adequacy that were discussed at that time.

The framework provides an indicative range for precautionary balances linked to developments in total credit outstanding. The reserve coverage ratio of 20-30 percent draws on approaches in other IFIs, adapted to the specific circumstances of the Fund. The credit measure used to determine the range includes a strong forward-looking element while also seeking to smooth credit volatility. Commitments under precautionary arrangements are currently excluded from the credit measure, but are taken into account when the Board exercises judgment on where to set the target.

Staff proposes that the indicative medium-term target for precautionary balances remain unchanged at SDR 20 billion. This is broadly consistent with the mid-point of the updated indicative range. The forward-looking credit measure has declined moderately since the last review and market indicators suggest that correlated risks have also declined. However, the Fund still faces large concentrated exposures that are expected to increase further and together will substantially exceed the target for an extended period. Also, undrawn commitments remain large, the average maturity of Fund credit has lengthened, and the Fund’s credit capacity has increased further as a result of the 2012 bilateral borrowing agreements.

The expected pace of reserve accumulation will depend on upcoming Board reviews of Fund charges. Based on the illustrative assumptions presented in this paper, staff projects that the SDR 20 billion target is expected to be reached in FY 2017-FY 2018.

The policy of publication of staff reports and other documents allows for the deletion of

market-sensitive information.

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International Monetary Fund

Washington, D.C.

January 14, 2014

mailto:[email protected]

http://www.imf.org/

REVIEW OF THE ADEQUACY OF THE FUND’S PRECAUTIONARY BALANCES

2 INTERNATIONAL MONETARY FUND

Approved By Andrew Tweedie

Prepared by the Finance Department

CONTENTS

INTRODUCTION _________________________________________________________________________________ 4

THE ROLE OF PRECAUTIONARY BALANCES AND THE FRAMEWORK FOR ASSESSING RESERVE

ADEQUACY ______________________________________________________________________________________ 4

A. Role of Precautionary Balances ________________________________________________________________ 4

B. Framework for Assessing Reserve Adequacy __________________________________________________ 12

DEVELOPMENTS SINCE THE LAST REVIEW ___________________________________________________ 15

ASSESSMENT OF THE ADEQUACY OF PRECAUTIONARY BALANCES ________________________ 22

CONCLUSIONS AND ISSUES FOR DISCUSSION _______________________________________________ 34

BOXES

1. The Composition of the Fund’s Precautionary Balances ________________________________________ 5

2. The Role of the Fund’s Burden Sharing Mechanism and Precautionary Balances in the Event of

Arrears ____________________________________________________________________________________________ 9

3. International Financial Reporting Standards ___________________________________________________ 11

4. Overview of Other IFIs’ Risk Management Practices ___________________________________________ 14

5. A Market-Based Measures of Correlated Risk _________________________________________________ 27

FIGURES

1. Framework to Determine the Indicative Target for Precautionary Balances ___________________ 13

2. Total Commitments, Credit Outstanding and Credit Concentration: 1994–2013 ______________ 16

3. Projected Credit Outstanding at the Time of Recent Reviews: 2010, 2012, 2013 ______________ 17

4. Credit Concentration by Region: 1980–2013 __________________________________________________ 18

5. Average Maturity of GRA Arrangements: 1995–2013 __________________________________________ 19

6. Precautionary Balance Ratios: FY 2000–FY 2013 _______________________________________________ 21

7. Repurchases in the GRA: FY 2010–FY 2020 ____________________________________________________ 22

8. Precautionary Balances and Average Largest Exposures: 2010–2018 __________________________ 26

9. Credit Outstanding and Credit Capacity: 1980–2014 __________________________________________ 29

10. The Fund’s Precautionary Balances: FY 2000–FY 2019 ________________________________________ 32

11. Precautionary Balances Under Different Policy Scenarios: FY 2013–FY 2019 _________________ 33

TABLES

1. Financial Risk Mitigation in the Fund ___________________________________________________________ 6


INTERNATIONAL MONETARY FUND 3

2. Current versus Past Reviews: 2008–2013 ______________________________________________________ 15

3. Precautionary Balances in the GRA: 2007–2013 _______________________________________________ 20

4. Target for Precautionary Balances with a Built-In Floor: FY 2002–FY 2016 _____________________ 24

5. Projected Accumulation of Precautionary Balances: FY 2013–FY 2019 _________________________ 34

ANNEXES

I. Assessing the Potential for Drawings under Precautionary Arrangements _____________________ 35

II. Market Risk and the Investment Mandate _____________________________________________________ 38

III. Burden Sharing Capacity, Credit Scenario Analysis and Stress Testing of the Fund’s Balance

Sheet ____________________________________________________________________________________________ 43



INTRODUCTION1

1. This paper reviews the adequacy of the Fund’s precautionary balances (Box 1). It uses

the more transparent and rules-based approach for assessing reserve adequacy agreed by the Board

in 2010. It also revisits several issues relating to the assessment of reserve adequacy that were

discussed at the time of the last review. The paper concludes that no change in the indicative

medium-term target for precautionary balances is needed at this time.

2. This review takes place on a standard two-year cycle and the paper’s timing allows the

assessment of reserve adequacy to inform upcoming Board reviews of Fund charges.2 The

review precedes the decision to be taken in April 2014 setting the basic margin for the rate of

charge for FY 2015 and FY 2016 and the review of access and surcharges planned for March. The

paper will also inform the forthcoming review of the FCL/PLL/RFI in February, which is expected to

consider among other issues the level and structure of commitment fees.

3. The paper is organized as follows. The first section reviews the role of precautionary

balances in the Fund’s framework for mitigating financial risks and the adoption of a more rules-

based framework for assessing reserve adequacy. The second section takes stock of developments

since the last review, while the third section assesses the adequacy of the current target for

precautionary balances in light of these developments. The last section concludes.

THE ROLE OF PRECAUTIONARY BALANCES AND THE

FRAMEWORK FOR ASSESSING RESERVE ADEQUACY

A. Role of Precautionary Balances

4. The Fund faces a range of financial risks in fulfilling its mandate (Table 1):

Credit risks typically dominate, reflecting the Fund’s core role of providing balance of payments

support to members when other financing sources may not be readily available. Credit risks can

fluctuate widely since the Fund does not target a particular level of lending or lending growth,

and Fund lending can also be highly concentrated and subject to correlated risks.

1 Prepared by a team led by D. McGettigan comprising: A. Attie, S. Davidovic, H. Imamura, L. Kohler, I. Lamba,

J. Mburu, D. Nana, M. Nkusu, A. Perez, S. Rodriguez, and B. Yuen under the guidance of D. Andrews (all FIN).

2 Reviews of the adequacy of precautionary balances have been on a two year cycle since 2002 but can be brought

forward by the Executive Board if needed.



Box 1. The Composition of the Fund’s Precautionary Balances

The Fund’s precautionary balances comprise retained earnings (the Fund’s general and special

reserves) that are not linked to the gold profits from the recent limited gold sales and the Special

Contingent Account (SCA-1). Reserves are available to absorb financial losses, including credit or

income losses:

Special Reserve. The special reserve was established in 1957. The Board also agreed in 1957 that any

administrative losses would first be charged against the special reserve. The special reserve is therefore

the first line of defense against income losses.1 Under the Fund’s Articles, no distributions can be made

from the special reserve.

General Reserve. The general reserve is available for absorbing capital or meeting administrative

losses, as well as for making distributions. Distributions of the general reserve are to be made to all

members in proportion to their quota, and require an Executive Board decision adopted by a

70 percent majority of the total voting power.

Special Contingent Account (SCA-1). Set up in 1987 with the specific purpose to protect the Fund

against the risk of a loss resulting from the ultimate failure of a member to repay its overdue charges

and repurchases in the GRA. The SCA-1 has primarily been funded through burden sharing

contributions generated equally from debtors and creditors through adjustments to the rates of charge

and remuneration, respectively.2 SCA-1 accumulations were suspended effective November 1, 2006.

The accumulated balances in the SCA-1 are to be distributed to contributing members when there are

no outstanding overdue obligations or at such earlier time as the Fund may decide. The decision to

distribute SCA-1 balances requires a 70 percent majority of the total voting power.

_____________ 1 Executive Board Decision No. 708-(57/57). This decision has been applied in the financial years the Fund has since suffered a

loss covering some SDR 342 million in losses, i.e., FY 1972–FY 1977 (SDR 103 million), FY 1985 (SDR 30 million), and FY 2007–FY

2008 (SDR 209 million). 2 In FY 1987, the SCA-1 was initially funded from GRA income in excess of the target for the financial year.



Table 1. Financial Risk Mitigation in the Fund

Financial Risk

Risk Mitigation Measures

Credit risk: The risk that a borrower

could fail to meet its financial obligations

to the Fund

Lending policies (e.g., conditionality, access limits, charges and maturities, exceptional

access framework)

De facto preferred creditor status

Safeguards assessments

Arrears strategy

Burden-sharing mechanism

Co-financing of arrangements by other official lenders

Precautionary balances

Liquidity risk: The risk that available

resources will not be sufficient to meet

financing needs of members and the

Fund’s obligations under borrowing

agreements

Monitoring of Forward Commitment Capacity (continuous)

Financial Transactions Plans (quarterly)

Liquidity reviews (semi-annually)

General quota reviews (every five years)

Bilateral borrowing and note purchase agreements; NAB and GAB


Income risk: The risk that the Fund’s

annual income may not be sufficient to

cover its annual expenditures.

Margin on the basic rate of charge

Surcharges

Burden sharing mechanism

Investment Account and investment mandate


Interest rate risk: The risk that future

cash flows will fluctuate because of

changes in market interest rates

The Fund does not incur interest rate risk on credit as it uses a floating market interest

rate (SDR interest rate) to determine the rates of charge and remuneration.

The interest rate risk of the Fund’s non-gold investment portfolio is reduced by

limiting the duration of the portfolio to a weighted average of 1-3 years. The gold

portfolio is currently invested in short-term deposits pending implementation of the

investment strategy. Going forward, and in light of the expanded investment authority,

the Executive Board will review the investment strategy of the non-gold portfolio; the

gold-related endowment will be gradually invested over three years in a diversified

strategic asset allocation approved by the Board in early 2013.

Exchange rate risk: The exposure to the

effects of fluctuations in foreign currency

exchange rates on the Fund’s financial

position and cash flows

The Fund has no exposure on its holding of member currencies, Fund credit, or

borrowings which are all denominated in SDRs, the Fund’s unit of account. Members

are required to maintain the SDR value of the Fund’s holdings of their currencies.

Exchange rate risk on investments is managed by investing in financial instruments

denominated in SDRs or in constituent currencies with a view to matching currency

weights in the SDR basket, and in the case of the endowment subaccount, by partially

hedging developed country currencies into the US dollar, which is the unit of account

of this subaccount.

Operational risk in financial matters:

The risk of loss attributable to errors or

omissions, process failures, inadequate

controls, human factors, and/or failures in

underlying support systems

Internal control procedures and processes

Executive Board approved investment guidelines for external asset managers

Audit arrangements: independent external audit, oversight of controls and financial

processes by an independent external audit committee, and an internal audit function




The Fund also faces income risks—the risk of shortfalls in annual income relative to expenses.

These risks have been significant in the past, including when lending fell to very low levels in the

period prior to the recent global crisis. Further progress has been made in implementing the

Fund’s new income model, which is intended to mitigate these risks by providing a sustainable

source of income to meet the costs of non-lending activities. In addition, the increasing level of

precautionary balances—which generate investment income for the Fund as well as being a

critical part of the risk mitigation framework—adds further protection to the Fund’s income.

The Fund faces liquidity risk—the risk that the Fund’s resources will be insufficient to meet

members’ needs. Quota reviews are the key medium-term mitigating factor, and the Fund can

also borrow temporarily to supplement its quota resources, as it has done in response to the

recent global crisis. In addition, the Fund retains a prudential balance of quota resources to

manage liquidity risks and provides a buffer to support the encashability of members’ reserve

tranche positions.3

The Fund does not currently face significant market (exchange and interest rate) risks in its

lending and funding operations with members. While market risks associated with the Fund’s

investment portfolios have increased somewhat, they currently remain modest, mitigated by the

narrow range of instruments in which the Fund currently invests its reserves. However, under the

expanded investment mandate, market risks will likely increase and these risks will be assessed

at the next scheduled review of precautionary balances, or earlier, if warranted.4 The Fund self-

insures for certain risks (for example, to cover losses of a capital nature) and faces limited

operational risks, reflecting its strong internal controls.

5. The Fund employs a multi-layered framework for managing credit risks. The primary

tools are Fund policies on access, program design, and conditionality, which are critical for ensuring

that Fund financial support helps members resolve their balance of payments difficulties in a timely

manner. These policies include assessments of members’ capacity to implement adjustment policies

and repay the Fund, and the exceptional access policies. The framework also includes the structure

of charges and maturities (which provide incentives for timely repurchases), safeguards assessments,

requirements for adequate financing assurances including from other official lenders, and the Fund’s

de facto preferred creditor status. In the event that arrears arise, the Fund has an agreed strategy for

addressing them. This includes the burden sharing mechanism for deferred charges aimed at

3 The prudential balance is currently set at 20 percent of the quotas of members participating in the financing of IMF

transactions (Financial Transactions Plan) and amounts made available under active bilateral borrowing and note

purchase agreements that do not provide a buffer for encashment calls. The prudential balance does not cover the

encashment needs of NAB participants’ outstanding claims under bilateral borrowing agreements folded into the

NAB; nor does it extend to the claims of participants in the expanded NAB, as such resources are provided by setting

aside a portion of the total credit arrangements under the NAB. The same holds for claims that could arise under the

2012 bilateral borrowing agreements.

4 See IMF Approves New Rules and Regulations for Investment Account, PR No. 13/37, February 4,2013

http://www.imf.org/external/np/sec/pr/2013/pr1337.htm.

http://www.imf.org/external/np/sec/pr/2013/pr1337.htm



protecting the Fund’s income from overdue charges, although the capacity of this mechanism

remains very limited at current low SDR interest rates and given heavy reliance on borrowed

resources (see Annex III). It also includes the maintenance of an adequate level of precautionary

balances as discussed below. Moreover, the Fund’s cooperative nature is of crucial importance when

credit risks materialize (Boxes 2 and 3).

6. Maintaining an adequate level of precautionary balances is a key element of the

Fund’s overall strategy for managing financial risks and ensuring the strength of the Fund’s

balance sheet. Precautionary balances are available to protect the balance sheet in the event that

the Fund were to suffer a loss as a result of credit or other financial risks.5 In this way, they play an

important role in protecting the value of reserve assets that members place with the Fund and

underpinning the exchange of international reserve assets through which the Fund provides

assistance to members with financing needs.6

7. The Fund conducts regular, biannual reviews of the adequacy of precautionary

balances. The Board adopted an SDR 10 billion target in 2002 in light of the increasing risks arising

from large financial arrangements with several middle-income countries. The SDR 10 billion target

was subsequently reaffirmed on three occasions in 2004, 2006, and 2008.

8. A more transparent rules-based framework for assessing precautionary balances was

endorsed by the Board during the 2010 Review and applied again in 2012.7 Based on this

framework, the Board agreed in 2010 to raise the indicative medium-term target to SDR 15 billion in

light of the sharp increases in commitments and actual and projected lending, the projected rises in

individual exposures, and the limited capacity of the burden sharing mechanism. The target was

further increased to SDR 20 billion in 2012 given the continued increase in lending and

commitments since the 2010 review. A minimum floor for precautionary balances of SDR 10 billion

was also agreed in 2010 and reaffirmed in 2012.

9. Directors noted that the framework will need to be kept under review and refined, as

needed, in light of further analysis and experience. They noted that the framework only serves as

a guide for determining the appropriate indicative target for precautionary balances and

emphasized the importance of judgment and the use of Board discretion in light of a broad

assessment of the financial risks facing the Fund.

5 The Fund drew on its precautionary balances during FY 2007–FY 2008 to cover income losses.

6 Although the Fund’s gold holdings are an important factor of strength in the Fund’s balance sheet, they offer

limited protection against arrears. In particular, outside of a liquidation of the Fund the use of gold by the Fund is

restricted by the Fund’s Articles and any authorized use requires a decision by an 85 percent majority of the total

voting power.

7 See Public Information Notice (PIN) No. 10/137 September 30, 2010

http://www.imf.org/external/np/sec/pn/2010/pn10137.htm and Press Release No. 12/132

April 12, 2012 http://www.imf.org/external/np/sec/pr/2012/pr12132.htm.

http://www.imf.org/external/np/sec/pn/2010/pn10137.htm




Box 2. The Role of the Fund’s Burden Sharing Mechanism and

Precautionary Balances in the Event of Arrears

The burden sharing mechanism seeks to ensure that the Fund’s cash flow from its lending

operations is not negatively impacted by members’ failure to settle financial obligations to the

Fund.1 Under burden sharing, temporary financing in equal amounts is obtained from debtor and

creditor members by increasing the rate of charge and reducing the rate of remuneration on reserve

tranche positions, respectively, to: (i) cover income shortfalls due to unpaid charges (“deferred

charges”) and (ii) accumulate precautionary balances against possible credit default (both overdue

charges and repurchases) in a contingent account (the SCA-1).

To the extent that burden sharing makes the Fund’s income position whole, the Fund can

continue to assert that there is no impairment loss under International Financial Reporting

Standards (IFRS) (see also Box 3). In particular, even though a member may not be meeting its

obligation to pay charges, the “collection” of an equivalent amount from other members through the

burden sharing mechanism enables the Fund to demonstrate that on a net present value basis there is

no impairment of credit outstanding under the current incurred loss model (see Box 3).

However, should the loss of income exceed the capacity of burden sharing, the difference would

reduce the Fund’s net income during the period in which the loss is incurred. In these

circumstances, the carrying value of the asset in arrears on the Fund’s balance sheet would need

to be reassessed.

The non-receipt of charges would lower annual net income and reduce the pace of accumulation

of precautionary balances.

The reduction in future cash flows due to the limited capacity of the burden sharing mechanism

could undermine the Fund’s ability to demonstrate that the carrying value of credit outstanding

has not been impaired. This would have implications for the accounting treatment of credit

outstanding on the Fund’s balance sheet, including the possibility of an impairment loss.2 Under

IFRS, should an impairment loss be recognized, the carrying value of the credit outstanding in

arrears could be reduced either directly or through the use of an allowance account.3 A variety of

factors would need to be considered in addressing this question, including the unique nature of

the Fund’s financing mechanism and the associated provisions in the Fund’s Articles, but

recognizing an impairment loss would further reduce net income and possibly precautionary

balances.4

Precautionary balances play an important role in protecting the Fund’s balance sheet by

providing a buffer to absorb potential losses. The SCA-1 serves as the first line of defense should

the Fund ultimately recognize an actual loss. Any such loss would be charged against the SCA-1, and

losses that exceed balances in that Account would lead to a reduction in the Fund’s income, and

possibly the Fund’s reserves. Annex III provides burden sharing capacity and credit scenario analyses



Box 2. The Role of the Fund’s Burden Sharing Mechanism and

Precautionary Balances in the Event of Arrears (concluded)

and stress tests of the Fund’s balance sheet that illustrate the critical role of precautionary balances.

________________________________________

1 See Annex III of Review of the Adequacy of the Fund’s Precautionary Balances (8/25/10) for more details on structure and

capacity of the Burden Sharing Mechanism. 2 Under IFRS, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of

estimated future cash flows. 3 The recognition of an impairment loss is not equivalent to writing off the outstanding claims against the member in arrears. The

recognition of an impairment loss does not relieve the member of its obligations to the Fund. If the amount of impairment loss

decreases as a result of events (e.g., settlement) occurring after the impairment was recognized, the previously recognized

impairment loss can be reversed. 4

Current accounting standards do not provide any specific methodology on measuring impairment losses, but recognize that

any impairment loss is measured as the difference between the asset’s carrying amount and the present value of estimated

future cash flows using the effective interest rate. The Fund is subject to limitations on loss recognition under the Articles of

Agreement. These limitations would need to be taken into account in addressing impairment losses in the context of arrears.



Box 3. International Financial Reporting Standards

Accounting requirements. While not required under the Articles, the Fund prepares its annual

financial statements in accordance with International Financial Reporting Standards (IFRS). IFRS require

that financial assets be measured and reported on the balance sheet at amortized cost or fair (market)

value. For example, on the Fund’s balance sheet, loan receivables (Fund credit) are carried at their

amortized cost, i.e., outstanding principal obligations, while investments are carried at their fair value.1

When the carrying (or book) value of an asset (either a loan or investment) exceeds its true realizable

value, adjustments are required to reflect such assets at their true recoverable or realizable amount.

Under current provisions, an entity shall assess at the end of each reporting period whether there is

objective evidence (a “loss event”) that assets carried at amortized cost are impaired. Under this

incurred loss model, a loss event could be a default or delinquency in interest or principal payments.2

The adjustment is measured as the difference between the asset’s carrying amount and the present

value of expected future cash flows. The reductions in the value of an asset are normally charged

against income and either the asset values carried on the balance sheet are reduced directly by an

equivalent amount or an allowance account is established, i.e., use of an equivalent provision.3 At the

Fund, such charges against income would need to be weighed against the burden sharing capacity for

deferred charges and the amounts in the SCA-1, which was established as a general precaution to

absorb losses from overdue obligations (overdue charges and repurchases).4

General prudent financial and accounting practices necessitate that an adequate level of reserves be

maintained, in addition to the specific provisions for value impairment, to ensure the viability and

continued operation of an entity and provide protection against general business risk.

Audit requirements. The failure to adjust the valuation of assets or use of allowance accounts on the

balance sheet in accordance with IFRS could cause an auditor to conclude that these assets are not

fairly stated and, when such amounts are significant, this could result in a qualified audit opinion.5

Further, if the overall available resources of an entity were to be considered inadequate to guarantee

continued operations or if there were considerable uncertainty about the ability of an entity to honor

its liabilities the auditor would need to consider the impact on its audit opinion on the financial

statements.

IAS 19 and Fund pensions. Precautionary balances are also affected by the accounting treatment for

the Fund’s obligation for pension and post-employment benefits and the related expense prescribed

under IAS 19. The present value of the obligation is actuarially determined based on demographic and

financial assumptions (e.g., discount rate). These assumptions change from year to year, thereby giving

rise to actuarial gains and losses. Since the adoption of IAS 19, the Fund has deferred the recognition

of such gains and losses, as permitted under the current standard, and carried them forward on the

balance sheet. The actuarial gains and losses have then been amortized and recognized into income

over time. IAS 19 has been amended and, effective in FY 2014, would disallow the deferral of actuarial

gains and losses. The adoption of the amended IAS 19 requires retrospective application such that any

cumulative unrecognized losses as reported in the audited financial statements would be charged



Box 3. International Financial Reporting Standards (concluded)

against the Fund’s reserves. Going forward, the immediate recognition of the effect of changes in

actuarial assumptions would flow through to, and give rise to volatility in, the Fund’s income and

reserves. No allowance for possible IAS 19 adjustment has been included in the projections shown in

this paper. As of end-FY13, cumulative unrecognized losses amounted to SDR 1.4 billion. However,

while it is premature to predict the final outcome, developments in the current financial year point

towards a potential reversal of those unrecognized losses. The forthcoming paper on the Fund’s

income position is expected to discuss this issue in more detail.

_______________________ 1 The IFRS accounting treatment is based on the economic substance of the Fund’s lending arrangements and not the legal form

of the underlying transactions, which involve the purchase and repurchase of currencies. 2 Discussions continue on when to shift to reporting standards based on an expected loss model. Under the expected loss model,

a loss event would no longer need to occur before an impairment loss is recognized. Due to this revision, it is anticipated that

the expected credit loss model would likely result in earlier recognition of credit losses compared with the current incurred loss

model. 3 When the issue of provisioning was last discussed by the Executive Board in 1987, the Board rejected both special and general

provisioning as tools for protecting the Fund’s financial position against the risk from overdue financial obligations . The

Executive Board would have to revisit the issue of loss recognition and provisioning in the event of significant arrears. 4 If the capacity of burden sharing for deferred charges was such that it could not absorb the full amounts of delinquent interest

payments, then the Fund’s income statement for the reporting period would no longer recognize income for the interest not

covered by burden sharing. Further charges against income would be needed to take account of any reduction in the carrying

value of the loan receivable after assessment of the protection provided by SCA-1. 5 A qualified opinion is issued when auditors disagree with the treatment or disclosure of a material matter in the financial

statements.

B. Framework for Assessing Reserve Adequacy

10. Under the framework, the target for precautionary balances is broadly maintained

within a range linked to developments in total credit outstanding. The framework provides an

indicative range that serves as a guide to decisions on adjusting the target over time, and the Board

retains flexibility to determine where the target should be set based on a comprehensive assessment

of the risks facing the Fund. It is generally envisaged that the target will be maintained within the

range, but there could be occasional circumstances where the Board would decide to set or

maintain the target outside the range if this is warranted by a broader assessment of financial risks.

11. The framework consists of four main elements (Figure 1): (i) a reserve coverage ratio, set

to 20 to 30 percent of a forward-looking credit outstanding measure, subject to a floor. This element

draws on approaches in other IFIs (Box 4), adapted to the specific circumstances of the Fund (in

particular the highly concentrated needs-driven nature of its lending portfolio), (ii) a forward-looking

credit measure to anchor the range—specifically, a three-year average of credit outstanding

covering the past twelve months and projections for the next two years—which helps smooth year-

to-year volatility of credit movements,8 (iii) commitments under precautionary arrangements, which

8 Given the inherent difficulty of forecasting future credit demand, the two-year projection is based on scheduled net

disbursements under non-precautionary arrangements, similar to the methodology used in the medium-term income

projections. Staff considers this a reasonable approach. While the methodology makes no provision for possible

(continued)



Indicative target

for Precautionary

Balances

Framework Judgment Outcome

are excluded from the credit measure used to derive the indicative range, but are considered by the

Board in setting the target, and (iv) a minimum floor—currently set at SDR 10 billion—to protect

against an unexpected increase in credit risks, particularly after periods of low credit, and ensure a

sustainable income position.9

Figure 1. Framework to Determine the Indicative Target for Precautionary Balances

future arrangements (which could bias the projections downwards) it also assumes the timely completion of all

reviews and related purchases under existing arrangements, with no provision for early repurchases (which could bias

the projections upwards). See also Review of the Adequacy of the Fund’s Precautionary Balances (8/25/10)

http://www.imf.org/external/np/tre/risk/2010/082410.htm.

9 While Fund credit is highly volatile and can increase sharply, it takes a considerable time to rebuild precautionary

balances. Thus the floor provides a buffer in the face of an unexpected increase in credit risks. The initial floor of SDR

10 billion was retained under the 2012 review of precautionary balances, consistent with past practices and in line

with the 10-year average of credit outstanding. The floor is kept under review in light of longer-term trends in Fund

lending.

http://www.imf.org/external/np/tre/risk/2010/082410.htm



Box 4. Overview of Other IFIs’ Risk Management Practices

This box summarizes the risk management approach of selected International Financial Institutions

(IFIs). The institutions reviewed are the International Bank for Reconstruction and Development

(IBRD), the Inter-American Development (IDB), the Asian Development Bank (ADB), the African

Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), and the

Bank for International Settlements (BIS).1

Capital adequacy framework. The IBRD, the IDB, and the ADB employ, or employed until recently,

an explicit target for equity to loan types of measures. The IBRD sets a target for the equity-to-loans

ratio in the range of 23-27 percent; the ratio at end-June 2013 stood at 26.8 percent. The IDB had a

target for its equity-to-loans ratio of 32-38 percent. While currently using the capital utilization ratio

as the main indicator of capital adequacy, the IDB continues to publish the equity-to-loans ratio

(31.1 percent at end-2012) in its information statements to investors. Similarly, the ADB previously

had an equity-to-loans ratio target of 35 percent; under its current framework, the ADB uses the

ratio in assessing the impact of stress scenarios. The capital adequacy frameworks of the remaining

IFIs are generally built on economic capital policy measures, where the required economic capital to

mitigate risks is managed within the level of available capital.

Market risks. Treatment of market risks in the IFIs’ capital adequacy frameworks varies. The capital

adequacy frameworks of the IBRD and the ADB focus on credit risks, and market risks are managed

mainly through asset-liability management. Other IFIs have integrated market risks in their capital

frameworks, although the specific risks covered and the amount of allocated capital vary

considerably. The IDB requires the minimum capital of five percent of the size of its investment

portfolio. The AfDB allocates risk capital equivalent to 1.9 percent of its total on-balance sheet risk

capital resources to counterparty credit risks related to their investments and derivative instruments.

The EBRD has established risk limits derived from an economic value-at risk approach. The BIS

determines the minimum capital requirements, based on the Basel II framework, to absorb potential

losses due to credit, market, operational and other risks; this minimum capital amounted to SDR 2.1

billion at end-March 2013, while the allocated capital was SDR 9.6 billion.

Operational risks. As in the case for market risks, treatment of operational risks varies across IFIs.

For the IBRD and the ADB, no capital is set aside for operational risks, which are managed mainly

through strong internal controls. The IDB allocates capital of one percent of total assets to

operational risks. The AfDB’s capital adequacy framework provides for an operational risk capital

charge of 15 percent of the average operating income for the preceding three years. The EBRD’s

required economic capital takes operational risks into account. The BIS allocates certain economic

capital to mitigate operational risks as described above.

_______________________________ 1 The 2010 precautionary balances paper (http://www.imf.org/external/np/tre/risk/2010/082410.htm) reviewed the capital adequacy

practices of the IBRD, the IDB, and the ADB, and the 2012 paper reviewed market and operational risk practices of these three

institutions plus the BIS.

http://www.imf.org/external/np/tre/risk/2010/082410.htm



DEVELOPMENTS SINCE THE LAST REVIEW

12. Developments since the last review confirm that credit risks remain elevated. Credit

outstanding and commitments remain near all-time highs, credit remains highly concentrated with a

few very large and correlated exposures, and the average maturity of Fund credit has lengthened.

Credit outstanding and total commitments remain high by historical standards (Table 2

and Figure 2, Panel A). Credit outstanding stood at SDR 84 billion at end-November 2013, near

its all-time high. At the time of the last review, credit outstanding was projected to peak at

about SDR 100 billion, whereas the actual peak was modestly lower at SDR 94.2 billion in April

2012, mainly reflecting purchases not made under arrangements that have now expired,

including with Iraq, Romania, and Ukraine (Figure 3). The current figure also includes projected

credit outstanding for four new programs approved since last April. Total commitments remain

very high at SDR 190 billion as of end-November 2013 (compared with about SDR 202 billion at

the time of the last review). Given the high level of outstanding commitments and still fragile

global outlook, it is too early to be confident that credit has peaked.

Table 2. Current versus Past Reviews: 2008–2013

Source: IMF Finance Department

1/ Review of the Adequacy of the Fund's Precautionary Balances, August 25, 2010.

2/ Unaudited staff estimates.

3/ Actual peak of SDR 94.2 billion was reached in April 2012.

4/ Total commitments equal GRA credit outstanding plus undrawn balances.

Oct-08 1/ Jul-10 1/ Feb-12 Nov-13

Precautionary balances 6.9 7.3 9.2 11.5 2/

Arrears 1.1 1.1 1.1 1.1

Largest individual exposure

Actual 5.7 9.0 17.5 23.6

Projected 11.0 26.4 28.1 27.6

Credit outstanding

Actual 17.2 48.6 88.5 84.1

Projected peak 30.0 78.2 100.6 87.1 3/

Total commitments 4/ 36.5 144.0 201.6 189.9

Credit capacity 165.9 310.1 451.4 668.7


Credit outstanding 40.5 15.1 10.4 13.7

Total commitments 19.0 5.1 4.6 6.1

Credit capacity 4.2 2.4 2.0 1.7

(In billions of SDRs)

(In percent of)



Figure 2. Total Commitments, Credit Outstanding and Credit Concentration: 1994–2013


0

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1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011 2012 2013

Credit Outstanding

Total Commitments =Credit Outstanding + Undrawn GRA Balances

Tequila crisis

Asian crisis

Brazil, Turkey and Argentina

Credit Outstanding 10yr average

A. GRA Total Commitments and Credit Outstanding, 1994 - November 2013 (in billions of SDR)

Greece, Ireland

and

Portugal

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5 Largest users

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Largest user

B. Largest Borrowers, 1994 - November 2013 (in percent of credit outstanding)

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5 Largest users

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Largest user

C. Largest Borrowers, 1994 - November 2013 (in billions of SDRs)



Figure 3. Projected Credit Outstanding at the Time of Recent Reviews: 2010, 2012, 2013



Credit concentration also remains very high, reflecting continued large lending to euro

area members. The top five largest borrowers account for about 86 percent of total credit at

end-November 2013 (Figure 2, Panel B), compared with 70 percent in early 2012. The degree of

regional concentration is also very high, with the top three borrowers, all members of the euro

area (Greece, Ireland, and Portugal), representing about 76 percent of credit outstanding (Figure

4); this compares with about 50 percent at the time of the last review. While high concentration

has been a feature of Fund lending in the past (Figure 2, Panel B), outstanding credit to the

largest borrowers has risen to new peak levels in SDR terms (Figure 2, Panel C).10

The risks

associated with these large exposures are also exacerbated by the potential for them to be

affected by correlated shocks.

10

More formally, the Herfindahl index—a commonly used measure of concentration—also shows that the

concentration of Fund lending has also risen further since the last review.

0

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Projected Credit Outstanding - March 2012

Projected Credit Outstanding - August 2010

Projected Credit Outstanding - November 2013



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1980 1984 1988 1992 1996 2000 2004 2008 2012

Western Hemisphere

Middle and Central Asia

Africa

Asia and Pacific

Euro Area

Rest of Europe

Figure 4. Credit Concentration by Region: 1980–2013 1/

A. In percent of total Fund Credit

B. In billions of SDRs


1/ Data as of August 2013.

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1980 1984 1988 1992 1996 2000 2004 2008 2012

Western Hemisphere

Middle and Central Asia

Rest of Europe

Asia and Pacific

Euro Area



The average maturity of Fund credit has lengthened since the 2012 review (Figure 5),

reflecting a continued increase in the share of total GRA credit accounted for by the three large

Extended Fund Facility (EFF) arrangements with euro area countries, where maturities of Fund

lending are longer than under Stand-by Arrangements (SBAs). Hence, although projected peak

credit outstanding has fallen somewhat, credit is projected to remain at elevated levels for

longer than was projected in 2010 and close to the levels projected in 2012 (Figure 3).

Credit capacity has increased significantly since the last review. At the time of the last

review, credit capacity had reached a new high of SDR 451 billion in February 2012 as a result of

the effectiveness of the expanded NAB. Since then, the Fund has mobilized substantial

additional resources through the 2012 bilateral borrowing agreements aimed at enhancing its

capacity to meet members’ potential needs in the context of its crisis prevention and resolution

activities. As a result, the Fund’s credit capacity has increased further to nearly SDR 670 billion as

of end-November 2013.11

The 2012 agreements provide a backstop to quota and NAB

resources, and are automatically activated if the modified FCC, which takes into consideration all

available uncommitted NAB resources (rather than those that have been activated, as is the case

with the FCC), falls below SDR 100 billion.

11

Allowing for a prudential balance of 20 percent, the 30 bilateral agreements totaling SDR 274 billion that were

effective at end-November 2013 raised the Fund’s credit capacity by SDR 219 billion.

Figure 5. Average Maturity of GRA Arrangements: 1995–2013

(In years)


3

4

5

6

3

4

5

6

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2008 2009 2010 2011 2012 2013

2012 ReviewPeak credit: Argentina,Brazil, and

Turkey

Peak credit:

Asian Crisis



13. Precautionary balances have increased since the last review, although they remain well

short of the indicative medium-term target and coverage of key metrics remains low:

Precautionary balances are now above the floor agreed at the last review (Table 3). At the

end of FY 2013, precautionary balances increased to SDR 11.5 billion, comprising retained

earnings in the special and general reserves of SDR 10.3 billion and SDR 1.2 billion in the Special

Contingent Account (SCA-1, see Box 1).

While precautionary balance coverage has increased modestly since the last review, it

remains low (Table 3 and Figure 6). Precautionary balances have increased to about 13 percent

of total credit outstanding, compared to about 10 percent at the time of the last review and

equate to 6 percent of total commitments, compared with less than 5 percent at the time of the

last review. However, including the lending capacity provided by the 2012 borrowing

agreements, precautionary balances have fallen to 1.8 percent of the Fund’s credit capacity

compared with over 2.0 percent at the last review. Moreover, precautionary balances still cover

only about one-half of each of the Fund’s three largest individual exposures.

Table 3. Precautionary Balances in the GRA: 2007–2013


1/ Precautionary balances as of end-FY 2011 exclude profits from gold sales (see Review of the Fund’s Income Position for FY 2010

and FY 2011 (4/14/10) http://www.imf.org/external/np/pp/eng/2010/041410.pdf).

2/ Precautionary balances in excess of arrears on principal.

3/ The Fund’s credit capacity is approximated by the quotas of members in the FTP plus resources made available under effective

bilateral loan and note purchase agreements plus resources that could be made available by activating the NAB and GAB,

excluding a prudential balance based on these combined resources.

4/ Total commitments equal credit outstanding plus undrawn balances under GRA arrangements.

5/ Obligations to the GRA that are overdue for six months or more.

2007 2008 2009 2010 2011 2012 2013

Precautionary balances 1/ 7.6 6.9 7.1 7.3 8.1 9.5 11.5

Reserves 5.9 5.8 5.9 6.1 6.9 8.3 10.3

General 3.5 3.5 3.5 3.5 4.0 4.9 6.1

Special 2.4 2.2 2.4 2.6 2.9 3.4 4.2

SCA-1 1.7 1.2 1.2 1.2 1.2 1.2 1.2

Free reserves 2/ 7.0 6.6 6.8 7.0 7.8 9.2 11.2

Memorandum items:

Credit capacity 3/ 166.3 166.7 219.5 309.2 451.2 451.6 635.2

Total commitments 4/ 11.2 9.0 72.2 117.5 181.5 201.6 198.2

Credit outstanding 7.3 5.9 20.4 41.2 65.5 94.2 90.2

Credit in good standing 6.8 5.6 20.1 40.9 65.3 93.9 89.9

Arrears 5/ 1.6 1.1 1.1 1.1 1.1 1.1 1.1

Principal 0.6 0.3 0.3 0.3 0.3 0.3 0.3

Charges 1.1 0.8 0.8 0.8 0.8 0.8 0.8

Precautionary balances to

Credit capacity 4.6 4.2 3.2 2.4 1.8 2.1 1.8

Total commitments 4/ 67.5 77.2 9.8 6.2 4.5 4.7 5.8

Credit outstanding 103.5 117.7 34.7 17.8 12.4 10.1 12.8

Free reserves to

Credit capacity 4.2 4.0 3.1 2.3 1.7 2.0 1.8

Credit in good standing 103.8 118.7 33.8 17.2 12.0 9.8 12.5

(End of Financial Year)

(In percent)


http://www.imf.org/external/np/pp/eng/2010/041410.pdf



Figure 6. Precautionary Balance Ratios: FY2000 – FY2013

(In percent)


1/ Total commitments equal credit outstanding plus undrawn balances under GRA arrangements.

14. Despite increased lending, arrears remain low. Current principal arrears total SDR 0.3

billion, and have not changed significantly in recent years. Members have so far been able to fully

meet their repurchase obligations falling due to the Fund, which rose in FY 2013 and are expected to

peak in FY 2014 at over SDR 20 billion (Figure 7) and remain high in FY 2015. Given the longer

maturity of average Fund lending, repurchase obligations are projected to rise and peak again in

FY 2021, declining to below SDR 5 billion only in FY 2024.

15. Near and medium-term income risks remain low. The still-high projected path for Fund

lending has underpinned the operational income outlook over the medium term envisaged at the

time of the last review.12

Positive net operational income is projected over the medium term, and

these surpluses, combined with substantial surcharge income and a gradual increase in investment

income in the outer years will allow the accumulation of precautionary balances in line with the

current target.13

12

The Consolidated Medium-Term Income and Expenditure Framework (4/30/13)

http://www.imf.org/external/np/pp/eng/2012/041212.pdf. Projections have been updated to reflect arrangements

approved through end-November 2013.

13

This partly reflects the recent agreement to broaden the Fund’s investment mandate and the phased

implementation of the new endowment. See IMF Approves New Rules and Regulations for Investment Account, PR No.

13/37, February 4, 2013, http://www.imf.org/external/np/sec/pr/2013/pr1337.htm.

0

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120

0

2

4

6

8

10

12

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Relative to credit capacity (left axis)

Relative to credit outstanding

Relative to total commitments 1/





Figure 7. Repurchases in the GRA: FY 2010 – FY 2020 1/



1/ Projected data as of FY 2014.

ASSESSMENT OF THE ADEQUACY OF PRECAUTIONARY

BALANCES 16. This section assesses the adequacy of precautionary balances in light of the above

developments. It also revisits the treatment of commitments under precautionary arrangements,

which Directors agreed to keep under review in light of experience. The section also presents the

results of scenario analysis covering alternative outlooks for future credit demand and stress tests of

the potential impact of arrears on the Fund’s balance sheet in light of the current very limited

capacity of the burden sharing mechanism.

17. Under the framework, the starting point for assessing reserve adequacy is the

forward-looking measure of credit outstanding. This measure stood at SDR 83.6 billion as of

November 2013 (Table 4, column 2), down moderately from SDR 91.8 billion at the time of the 2012

0

5

10

15

20

25

0

5

10

15

20

25

FY2010 FY2012 FY2014 FY2016 FY2018 FY2020



Review. As in the past, this projection assumes full and timely disbursements under all non-

precautionary arrangements approved to date, but makes no allowance for possible new

arrangements or for drawings under existing precautionary arrangements. It also assumes that all

repurchases are made as scheduled.

18. The midpoint of the indicative range based on this measure is SDR 21 billion. A 20-

30 percent indicative range for the precautionary balances target yields a range of SDR 16.7-25.1

billion (columns 3-4), with a mid-point of SDR 20.9 billion. This compares with a mid-point of SDR

23 billion at the time of the 2012 review (column 5). In 2012, staff proposed that the target be set

below the mid-point, noting that it would already imply more than a doubling from the then-current

level of precautionary balances, actual arrears remained very low, and the global situation and

potential demand for new Fund lending was highly uncertain. Directors supported this approach,

though a number saw a case for a higher target, given the potential further increase in the Fund’s

lending capacity through bilateral borrowing and the possibility of substantially higher lending.14

19. Based on the above considerations, staff believes that the current SDR 20 billion target

remains appropriate. This would be broadly in line with the mid-point of the indicative range

based on updated calculations, and reflects an assessment that the overall balance of financial risks

is largely unchanged since the last review. Total credit outstanding and financing commitments

remain high, some individual exposures remain very large and potentially subject to correlated risks,

and the Fund’s credit capacity has been expanded further to meet possible additional financing

needs. On the other hand, all members benefiting from Fund support during the crisis have so far

been able to fully meet their obligations to the Fund, and debt distress indicators have fallen sharply

over the past year. Earlier concerns about global tail risk events have also eased somewhat, raising

at least the possibility that Fund lending may have peaked. In the staff’s view, these and other

considerations do not provide a strong basis for deviating significantly from the mid-point of the

range. The following paragraphs elaborate on these considerations.

14

Press Release No. 12/132 April 12, 2012, http://www.imf.org/external/np/sec/pr/2012/pr12132.htm.




Table 4. Target for Precautionary Balances with a Built-In Floor: FY 2002 – FY 2016 1/



1/ Italicized figures reflect calculations at the time of the respective 2010 and 2012 reviews and as of November 2013. Figures

shown between FY 2002 and FY 2013 are actual outturns, not projections, and hence differ from the figures in the equivalent

tables from previous precautionary balance review papers. Figures for FY 2014 - FY 2016 are based on projections.

2/ For July 2010, February 2012, and November 2013, the figure shown reflects the average credit during the previous twelve

months (August 2009 - July 2010, March 2011 - February 2012, and December 2012 - November 2013, respectively).

3/ Three-year average based on one-year of backward looking data and projections two-years forward.

4/ The lower and upper bound correspond to 20 percent and 30 percent coverage for credit measure, respectively.

20. The Fund continues to have several very large exposures to individual members. Each

of the Fund’s two largest individual exposures currently exceed the precautionary balances target,

and the third largest is only slightly below the target. If all purchases and repurchases are made as

scheduled, total credit outstanding to Greece, Ireland, and Portugal combined would increase from

SDR 62 billion (or 73 percent of credit outstanding) as of end-November 2013 to over SDR 69 billion

(93 percent of projected credit outstanding) two years later. Moreover, the combined annual

average exposure to these three largest borrowers would remain in excess of three times the current

target through FY 2017, and the largest single exposure would remain above this target through

FY 2019 (Figure 8).

21. In addition to their scale, these exposures are all to euro area members and therefore

subject to potentially correlated risks. At the time of the last review, concerns about euro area

20% 30%

( 1 ) ( 2 ) ( 3 ) ( 4 ) ( 5 ) ( 6 )

FY-2002 51.2 59.8 12.0 17.9 14.9 4.6

FY-2003 61.6 61.4 12.3 18.4 15.4 5.4

FY-2004 66.5 52.3 10.5 15.7 13.1 6.4

FY-2005 56.1 34.0 6.8 10.2 10.0 7.2

FY-2006 34.2 17.5 3.5 5.3 10.0 7.6

FY-2007 11.7 10.5 2.1 3.1 10.0 7.6

FY-2008 6.6 18.3 3.7 5.5 10.0 6.9

FY-2009 13.1 34.4 6.9 10.3 10.0 7.1

July 2010 48.6 59.5 11.9 17.8 14.9 7.3

FY-2010 35.2 57.3 11.5 17.2 14.3 7.3

FY-2011 54.8 76.1 15.2 22.8 19.0 8.1

Feb. 2012 77.5 91.8 18.4 27.6 23.0 9.2

FY-2012 81.9 86.9 17.4 26.1 21.7 9.5

FY-2013 91.7 86.0 17.2 25.8 21.5 11.5

Nov. 2013 88.4 83.6 16.7 25.1 20.9 11.5

FY-2014 86.1 81.5 16.3 24.5 20.4 13.2

FY-2015 81.8 - - - - -

FY-2016 76.7 - - - - -

Coverage for

Average Credit

Outstanding 2/

Measure for Credit

Outstanding 3/

Credit Outstanding 4/Higher of Mid-point of

bounds or Minimum

floor of SDR 10 billion

Precautionary

BalancesLower Bound Upper Bound



risks and their potential global spillovers were near their peak. These concerns have since eased, and

recent market indicators suggest that implied joint probabilities of distress have fallen sharply,

though they remain elevated in some cases (Box 5). These developments suggest a reduction in the

Fund’s own credit risks associated with these exposures, though they also highlight the potential for

conditions to change rapidly. Given that the Fund’s largest exposures are now expected to decline

only gradually, as noted above, these potential risks may remain elevated for some time.

22. Commitments under precautionary arrangements have risen modestly since the last

review. Total commitments currently amount to about SDR 77 billion, compared with SDR 71 billion

at the 2012 review. Under the current framework, these commitments are taken into account when

setting the target for precautionary balances rather than in calculating the indicative range. This

approach was agreed in view of the historically low drawing rates under precautionary

arrangements.15

Most Directors supported this approach at the 2012 review, though a number

preferred to take precautionary arrangements more explicitly into account in the credit measure and

it was agreed to revisit this issue in light of experience.

23. Experience since the last review and further staff analysis suggest that the current

approach remains broadly appropriate. Since the last review, there have been no drawings under

the three FCL arrangements (with Colombia, Mexico, and Poland)—which account for the bulk of

precautionary arrangements—and only one SDR 0.2 billion drawing under the PLL arrangement for

Macedonia. Staff has also extended its analysis of the likelihood of drawings under precautionary

arrangements based on stress scenarios for selected external shocks (see Annex I).16

These scenarios

suggest that the probability of drawing would be relatively low at the 25th

percentile of shocks,17

but

would be significantly higher for shocks at the 10th

percentile. These results are illustrative and

unlikely to fully capture the range of possible shocks or the authorities’ policy responses to those

shocks. However, both this analysis and recent experience would seem to support the current

approach of excluding commitments under precautionary arrangements from the forward-looking

credit measure used to calculate the indicative range but taking them into account when setting the

target. Staff therefore proposes no change in how such commitments are treated at this time, but

that this issue be kept under review in light of future developments.

15

Historically, only about 2.5 percent of amounts available under precautionary arrangements were drawn between

1994 and end-July 2013.

16 The analysis, based on kernel distributions of key external variables across emerging market economies in 1991,

2001, and 2009, focuses on episodes of large declines (more than one standard deviation) in aggregate demand in

advanced economies. Univariate kernel distributions are then used to shock key components of countries’ balance of

payments, including exports, FDI, and short and medium and long term rollover rates. The impact of simultaneous

shocks on reserves and reserve coverage are applied to 2012 data on exports, FDI, short-term debt and amortization

of medium and long term debt to members with FCLs (Colombia, Mexico, and Poland), PLLs (Morocco), and large

SBAs treated as precautionary by authorities (Romania). 17

Countries with credit ratings similar to those of FCL-qualifying countries typically do not experience simultaneous

shocks in key balance of payments categories associated with the 25th

percentile of past shocks, although individual

components of highly-rated countries’ external accounts do, on occasion, witness shocks of this order of magnitude.

Moreover, assuming a shock at the 25th

percentile is typically more conservative than the shock scenarios assumed

under the various FCL requests to date.



Figure 8. Precautionary Balances and Average Largest Exposures: 2010–2018



1/ SDR 20 billion target in effect as of the 2012 review.

0

5

10

15

20

25

30

2010 2011 2012 2013 2014 2015 2016 2017 2018

Exposure - Top Credit User

Average Exposure - Top 3 Credit users

Average Exposure- Top 5 Credit Users

Indicative PB Target 1/



0

0.1

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0.9

1

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Jul-

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Oc

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3

Jan

-14

PORT/GRE IRL/GRE

IRL/POR POR/IRL

0

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Box 5. A Market-Based Measures of Correlated Risk

Information from sovereign credit default swaps (CDS) can be used to calculate implied probabilities

of distress (PoD). This analysis is widely used in the Fund in other contexts to gauge market views on credit

risks and interconnectedness. Market quotes of five-year sovereign credit default swap (CDS) spreads are

used to extract market expectations on the PoDs of specific borrowers, and to gauge perceived correlation of

risks using pairwise CoPoDs. These are estimated using dependence between individual PoDs as discussed in

Segoviano (2006) and Segoviano and Goodhart (2009). A matrix of distress dependence is derived. Each

element (i,j) of the dependence matrix shows the implied probability that a country i will get into distress

conditional on distress in country j. The joint PoD is the unconditional probability that all countries will get

into distress at the same time. See Euro Area Policies—Spillover Report—Selected Issues, Chapter III (7/5/11)

http://www.imf.org/external/pubs/ft/scr/2011/cr11185.pdf for the use of CoPoDs in a euro area context.

Market indicators suggest that correlated risks on the Fund’s largest exposures have fallen since the

last review (see figures below). Using information from sovereign credit default swaps (CDS), the implied

joint probabilities of distress (JPoDs) of the top three borrowers are estimated to have fallen, reflecting

improved market sentiment, particularly following the announcement in August 2012 of the ECB’s Outright

Monetary Transactions program. Likewise, conditional probabilities of distress (CoPoDs) for Portugal and

Ireland have generally fallen over the same period. For Greece, the POD is still near unity (not in the chart).

While the overall CoPoD declines reflect progress made in addressing the crisis in Europe, the realization that

market sentiment and the risk of correlated shocks can change swiftly underlines the need for adequate

precautionary balances to address these concentrated risks arising from the Fund’s large individual

exposures.

Joint and Conditional Probabilities of Distress (CoPoDs) in Greece, Ireland, and Portugal:

(January 2010 to January 2014) 1/

A. Joint Probability of Distress in All Three Countries B. Pairwise CoPoDs 2/

Source: Bloomberg and IMF Finance Department staff calculations

1/ January 13, 2014.

2/ Each line depicts the probability that the country mentioned first will get into distress conditional on distress in the

second country mentioned.

http://www.imf.org/external/pubs/ft/scr/2011/cr11185.pdf



24. Directors agreed in 2012 to include credit capacity and previous lending peaks among

the indicators for assessing where to set the target for precautionary balances. The rationale

for looking also at these indicators is that Fund lending can change rapidly with little advance notice,

so that current credit outstanding could underestimate exposure to credit risk in the future. The

practices of other financial institutions, including IFIs, do not provide guidance on an appropriate

level of reserves relative to credit capacity. However, in the past, the Board has implicitly endorsed a

ratio of reserves to credit capacity of 6 percent based on the target agreed in 2002 and reaffirmed

on three occasions through 2008 when the Fund’s credit capacity was broadly unchanged. Applying

this ratio to the Fund’s current credit capacity, including the 2012 bilateral borrowing agreements,

would yield a target of over SDR 40 billion, roughly double the current target. This compares with

SDR 27 billion at the time of the last review.

25. Data on past credit peaks have not changed since the last review. However, these data

serve as a reminder that demand for Fund credit can expand rapidly, and with it the need for

adequate precautionary balances. As evident from Figure 9, previous peaks in Fund credit have

increased steadily over the last three decades, reflecting increased global capital and trade flows,

which have the potential to lead in turn to large balance of payments needs in a crisis. Since these

underlying forces are expected to continue, it is likely that future peaks will continue to rise over

time, underscoring the potential for lending to exceed recent levels at some point in the future.

26. Precautionary balances also provide a buffer against potential financial losses

associated with operational and market risks. These risks are currently assessed to be limited (see

Annex II), and no explicit provision is made for them in the framework. Market risks associated with

the Fund’s investment activities will increase over time as the stock of reserves increases and with

the phased investment of the endowment. Interest rate risk in the reserves portfolio is controlled by

limiting the duration of the portfolio to a weighted average of 1–3 years. A review of the investment

strategy for the reserves portfolio is planned for 2014. Market risks associated with the SDR 4.4

billion endowment portfolio will be somewhat larger, but will be controlled in the short term by the

agreed strategy of phasing the investment of the endowment over three years. No change in the

framework to explicitly incorporate these risks is proposed at this stage, but staff plans to keep

these issues under review in light of developments in the Fund’s investment portfolios and on-going

broader work on the Fund’s risk management framework.



27. Balancing these various considerations, staff believes the current indicative target for

precautionary balances of SDR 20 billion remains appropriate. The framework seeks to avoid

frequent target changes and, since the target was increased at both the 2010 and 2012 reviews, the

existing target should be preserved unless there are compelling reasons for a further change. This

does not appear to be the case. The mid-point of the indicative range, based on credit outstanding,

is close to the current target. Although total credit outstanding is projected to decline gradually,

these projections make no allowance for possible new arrangements, including in the event that the

Fund needs to call upon its recently expanded credit capacity associated with the 2012 borrowing

agreements. The Fund also continues to face several large concentrated exposures that are set to

increase further, and will likely remain elevated for an extended period.

28. Scenario analysis and stress tests highlight the critical role of precautionary balances,

particularly given the Fund’s current very limited burden sharing capacity (see Annex III). The

current low interest rate environment severely constrains burden sharing capacity. This would

suggest that a moderate rise of charges in arrears could exhaust the current capacity and have

possible ramifications for the carrying value of assets on the Fund’s balance sheet (see Boxes 2 and

3). Under purely illustrative assumptions, stress tests suggest that charges in arrears associated with

principal the size of the average large borrower could exhaust net income and result in a reduction

Figure 9. Credit Outstanding and Credit Capacity: 1980–2014

(In billions of SDRs, end of Financial Year)


1/ Credit capacity is approximated by the sum of the quotas of FTP members, resources under effective loan and

note purchase agreements, and resources under NAB and GAB, excluding prudential balances.

2/ Data as of November 2013. Includes effective 2012 bilateral borrowing agreements of SDR 219 billion net of

prudential balances.

0

20

40

60

80

100

0

100

200

300

400

500

600

700

800

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 /2

Asian crisis

11th General

Review and

NAB

8th General Review

NAB

activations

Argentina,

Brazil & Turkey

2012 bilateral

agreements

Bilateral

agreements



in precautionary balances, though still leaving a sizeable buffer to handle any additional financial

shocks.

29. Staff does not see a strong case for changing the minimum floor for precautionary

balances of SDR 10 billion at this stage. Reserves are now above the floor for the first time under

the agreed framework and are projected to increase further in coming years. As long-term trends in

credit outstanding become clearer and the implementation of the income model progresses, the

level of the floor can be revisited alongside the related issue of the possible payment of dividends,

as envisaged in the design of the new income model.

Pace of Reserve Accumulation

30. At the 2012 review, most Directors agreed that the pace of reserve accumulation was

adequate but should be kept under close review. Staff projections suggested that reserves could

increase by an average of close to SDR 2 billion a year over the five years beginning in FY 2013, such

that the SDR 20 billion target would be largely attained by end-FY 2017 and surpassed by end-FY

2018. A few Directors supported accelerating the pace of accumulation by increasing the margin for

the rate of charge and changing the structure of surcharges, but a few other Directors cautioned

against these options given borrowers’ tight fiscal space and high debt.18

31. Directors will have an opportunity to consider several policies affecting the pace of

reserve accumulation in the coming months. These are:

The structure of commitment fees. Commitment fees have made an important contribution to

Fund income and reserve accumulation in recent years in the context of large scale

commitments under precautionary arrangements, particularly the FCL. The Board will have

an initial opportunity to consider possible changes to the structure of commitment fees in

the context of the forthcoming review of the FCL, PLL, and RFI, planned for February 2014.

The level and structure of surcharges. A review of the policies on access and surcharges is

planned for March 2014. This will be the first comprehensive review of surcharge policies

since the current structure was put in place in 2009. It will include consideration of whether

and how the level and thresholds for surcharges should be adjusted, including in light of the

effectiveness of the quota increase under the 14th

General Review of Quotas, and the

possible implications for the time based surcharges of increased lending under the Extended

Fund Facility (EFF) since the policies were last reviewed.

The basic margin for the rate of charge. The current margin of 100 basis points has been in

place since FY2009. In line with Rule I-6(4), the Board will review and set the margin for the

two year period FY2015–16 in April 2014 as part of the annual review of the Fund’s income.

18

The Acting Chair's Summing Up—Review of the Adequacy of the Fund's Precautionary Balances (4/17/12), Press

Release No. 12/132 April 12, 2012 http://www.imf.org/external/np/sec/pr/2012/pr12132.htm.




32. Detailed analysis to support the above discussions will be presented in future papers

and it would not be appropriate to prejudge the outcome of those reviews here. Rather, this

paper presents three purely hypothetical scenarios that seek to provide some sense for the

sensitivity of the pace of reserve accumulation to future decisions on the structure of charges. Two

scenarios update those presented previously in the context of the annual income and budget

discussions in April 2013.19

One assumes that there is no change in the margin for the basic rate of

charge, the level, structure and thresholds for surcharges, or the structure and thresholds for

commitment fees following the effectiveness of the 14th

General Review quota increases (the latter is

assumed to take place by March 1, 2014 purely for hypothetical and illustrative purposes). The

second assumes that the thresholds for surcharges and commitment fees are halved following the

effectiveness of the quota increases (this scenario is broadly equivalent to an alternative scenario

with no change in quotas or surcharge thresholds). The third scenario illustrates the impact of

extending the trigger for time-based surcharges20

for EFFs—a scenario considered at the time of the

2009 access and surcharges review— combined with a halving of the thresholds as in the second

scenario.21

As noted, these scenarios are purely illustrative, and are not intended to prejudge the

outcome of the upcoming reviews. A range of outcomes is possible and more detailed calculations

will be presented in future papers.

33. Under the scenarios presented in this paper, the SDR 20 billion target for

precautionary balances would be reached in the period FY 2017-FY 2018 (see Figure 10, panel B

and Figure 11).22

In the scenario in which the thresholds are halved and no other changes are made,

the pace of reserve accumulation would be very close to that projected at the time of the last

review. Under this scenario, the target would be reached end-FY 2017 (see Table 5). In the scenario

where no changes in charges or thresholds are made, the accumulation of precautionary balances

would be about 17 percent slower with precautionary balances standing at 18.7 billion at end

FY 2017 and the target reached in FY 2018. In the scenario that combines a halving of thresholds

with adjustment in the trigger for the time-based surcharges on currency holdings from purchases

under the EFF, the pace of reserve accumulation would be about 4 percent slower and the target

would be met in early FY 2018.23

19

The Consolidated Medium-Term Income and Expenditure Framework (4/30/13), Rev. 1

http://www.imf.org/external/np/pp/eng/2012/041212.pdf.

20

The illustrative scenario included here applies time-based surcharges after 4¼ years for extended arrangements. This is consistent

with the application of time-based surcharges in the credit tranches (e.g., stand-by arrangements), which apply three months before

repurchases start. Purchases in the credit tranches are repurchased in eight equal installments from 3¼ to five years; repurchases

for extended arrangements are made in twelve installments from 4½ to ten years.

21 See Charges and Maturities—Proposals for Reform (12/12/08) http://www.imf.org/external/np/pp/eng/2008/121208a.pdf. The role

of high access extended arrangements was not envisaged at the time of that review, and so the issue of time-based surcharges was

seen as essentially moot at the time. The situation has changed considerably since then, given the preponderance of high access

extended arrangements.

22 Due to varying quota increases by individual members—quotas are set to double on average but with some members seeing

larger quota increases and others seeing smaller increases—some members paying surcharges and commitment fees are set to

receive a quota increase of greater than 100 percent under the 14th

Review of quotas, lowering projected surcharge and

commitment fee income.

23 Although the target would be nominally attained early in the year taking account of accrued net income to date,

formally the target would be met only when reserves are increased following net income disposition decisions taken

at the end of the fiscal year.


http://www.imf.org/external/np/pp/eng/2008/121208a.pdf

REVIEW OF THE ADEQUACY OF THE FUND’S PRECAUTIONARY BALANCE


2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

-0.8

-0.4

0.0

0.4

0.8

1.2

1.6

2.0

2.4

-0.8

-0.4

0.0

0.4

0.8

1.2

1.6

2.0

2.4 Projections start

April 2013

EFF Time-Based adj.

No thresholdsThresholds adjustment

Figure 10. The Fund’s Precautionary Balances: FY 2000 – FY 2019

(In billions of SDRs, Financial Year)

A. Actual and Forecast Additions to Precautionary Balances, FY 2000 – FY 2019 1/

B. Actual and Forecast Precautionary Balances, FY 2000 – FY 2019 1/


1/ Excludes changes in SCA-2 balances in FY 2000. Illustrates projected accumulation of precautionary balances under current

approved arrangements and assumes effectiveness of 14th Review quotas on March 1, 2014 purely for hypothetical and illustrative

purposes. No threshold adjustment scenario reflects current pricing policies for surcharges and commitment fees. The threshold

adjustment scenario assumes halving surcharge and commitment fee thresholds to partially offset the incentive and revenue effects

of the quota increase. The threshold for level-based surcharges is reduced to 150 percent from 300 percent of quota upon

effectiveness of the new quotas. Commitment fee threshold are halved to 100 percent, 101-500 percent, and greater than 500

percent of quota for the charges of 15 basis points, 30 basis points, and 60 basis points, respectively. The level-based surcharge

thresholds are adjusted as in the adjusted scenario, and in addition, the trigger for time-based surcharges for EFFs is extended to

51 months (4¼ years) from 36 months (3 years).

2/ Net of costs associated with administering PRGF-ESF operations for the period FY 1998 - FY 2006. In FY 2007-FY 2010 surcharges

were used to help cover administrative expenses, rather than placed directly to general reserves.

3/ In FY 2000-FY 2006, additions to Special Reserves were adjusted for IAS 19 related accounting gains; in FY 2010 addition to

Special Reserves exclude profits from gold sales.

4/ SCA-1 accumulations were suspended from November 2007. In FY 2008, SDR 525 million was distributed to contributors.

5/ The initial application of the current framework in 2010 increased the target to SDR 15 bn from SDR 10 billion where it had been

since 2002, and introduced the current floor (see Review of the Adequacy of the Fund’s Precautionary Balances (8/25/10). In April

2012, the target was increased to the current level of SDR 20 billion.

0

5

10

15

20

25

0

5

10

15

20

25

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Threshold Adjustment

Threshold & EFF time-based Adjustments

No Threshold Adjustment

Projections start April 2013

Indicative target 5/

Floor

2010 PB Review

2012 PB Review



Figure 11. Precautionary Balances Under Different Policy Scenarios: FY 2013 – FY 2019



1/ Illustrates projected accumulation of precautionary balances under current approved arrangements and pricing policies,

assuming effectiveness of 14th Review quotas on March 1, 2014 purely for hypothetical and illustrative purposes.

2/ Illustrates projected accumulation of precautionary balances under current approved arrangements, assuming effectiveness of

the 14th

Review quota on March 1, 2014 purely for hypothetical and illustrative purposes and halving surcharge and commitment

fee thresholds to partially offset the incentive and revenue effects of the quota increase. The threshold for level-based surcharges is

reduced to 150 percent from 300 percent of quota upon effectiveness of the new quotas. Commitment fee threshold holds are

halved to 100 percent, 101-500 percent, and greater than 500 percent of quota for the charges of 15 basis points, 30 basis points,

and 60 basis points, respectively. The effect of commitment fees is minimal and no change is assumed in the current fiscal year. Due

to the asymmetry of quota increases on a by-member level not all lost income is recouped.

3/ The level-based surcharge thresholds are adjusted. In addition, the trigger for time-based surcharges for EFFs is extended to 51

months (4¼ years) from 36 months (3 years).

FY13

8

10

12

14

16

18

20

22

24

8

10

12

14

16

18

20

22

24

2013 2014 2015 2016 2017 2018 2019

SDR 20 billion indicative

target

Policy thresholds remain

unchanged 1/

SDR 10 billion floor

Policy thresholds

adjusted 2/

At the time of the April 2012

review

Thresholds & EFF Time-Based

Adjustment 3/



FY 13 FY 14 FY 15 FY 16 FY 17 FY 18 FY 19

At the time of the April 2012 review

Net operational income 1.1 0.7 0.7 0.7 0.7 0.8 …

Surcharge income 1.2 1.3 1.5 1.4 1.2 0.9 …

Increase in precautionary balances 2.3 2.0 2.2 2.1 1.9 1.7 …

End period precautionary balances 11.8 13.8 16.0 18.0 19.9 21.6 …

Based on current surcharge thresholds

Net operational income 1/ 0.8 0.4 0.7 0.4 0.5 0.8 0.8

Surcharge income 1.2 1.4 1.4 1.3 1.2 1.0 0.7

Increase in precautionary balances 2.0 1.7 2.1 1.7 1.7 1.7 1.6

End period precautionary balances 11.5 13.2 15.3 17.0 18.7 20.4 22.0

Based on adjusted surcharge thresholds (150%)





Based on adjusted surcharge thresholds (150% - EFF 4 years and 3 months)





Table 5. Projected Accumulation of Precautionary Balances: FY 2013 – FY 2019



1/ Adjusted for IAS 19 timing adjustment in FY13. Please see paragraph 3 of Review of the Fund’s Income Position for FY 2013

and FY 2014 http://www.imf.org/external/np/pp/eng/2013/043013a.pdf.

CONCLUSIONS AND ISSUES FOR DISCUSSION

34. This paper has reviewed the adequacy of precautionary balances and proposes that

the indicative medium-term target should be maintained unchanged at SDR 20 billion. This

proposal utilizes the rules-based framework adopted in 2010, and takes account of developments

since the last review was concluded in 2012. The paper concludes that the overall balance of

financial risks facing the Fund is largely unchanged since the last review. The paper also revisits

aspects of the framework that have been considered in previous reviews, including the treatment of

commitments under precautionary arrangements, and concludes that no changes are warranted at

this time. The paper also updates earlier projections of the pace of reserve accumulation, which will

be affected by several decisions in the coming months related to Fund charges. The paper proposes

that the minimum floor for precautionary balances of SDR 10 billion remain unchanged.

35. Directors may wish to comment on the following issues:

How do Directors assess the balance of financial risks facing the Fund since the last review of

precautionary balances in 2012?

Do Directors agree that the framework for assessing the adequacy of precautionary balances

remains broadly appropriate?

Do Directors agree that the medium-term indicative target for precautionary balances should be

maintained unchanged at SDR 20 billion and that the floor should remain at SDR 10 billion?




Annex I. Assessing the Potential for Drawings under Precautionary Arrangements

Using purely illustrative exercises, this annex assesses the potential use of the Fund resources by

members with precautionary arrangements. It estimates the impact of global shocks on exports,

foreign direct investment, and debt rollover rates, which in turn affects external financing and

international reserves of affected countries, using the Fund’s reserve adequacy metric (RAM) as a

guide. The idea of this exercise is to get a sense of how large a shock would be needed to lead a

member with a precautionary arrangement to draw on that arrangement.

A. The Data

For the purposes of the exercise, we use univariate kernel distributions of key external variables from

past crises, a key determinant of balance of payments need calculations in FCL and PLL Board

documents.1 The data underlying the kernel distributions identify moves in key external variables

across emerging market economies in 1991, 2001, and 2009, years of large declines (more than one

standard deviation) in aggregate demand for advanced economies. Univariate kernel distributions

are calculated for exports, FDI, and short and medium and long term rollover rates.

Illustrative percentile values for the contraction of exports and FDI, as well as for rollover rates, are

displayed in Table I. 1 for assumed shocks, with varying degrees of severity.2 At the 25

th percentile,

exports fall by almost 4 percent relative to the baseline, FDI by 45 percent, rollover rates for short

term debt are about 68 percent for public debt and 87 percent for private; rollover rates for medium

and long term debt are lower, about 52 percent for public debt and 58 percent for private debt.3 The

shocks are, naturally, more extreme at the 5th

and 10th

percentiles.

B. Potential Drawings under Precautionary Arrangements

The potential for drawing under precautionary arrangements is assessed by the magnitude of

international reserves relative to the Fund’s RAM, which is calculated by measuring reserves relative

to the stock of risk weighted liabilities facing the country. The risk weighted liability stock is in turn a

weighted average of short-term debt at remaining maturity, other portfolio liabilities, broad money,

and exports of goods and services, with weight of 30/10/5/5 percent, respectively.4 It is suggested

1 For a detail discussion the kernel distributions and the underlying data, see Review of the Flexible Credit and

Precautionary Credit Line (11/1/11) http://www.imf.org/external/np/pp/eng/2011/110111.pdf.

2 Shocks to exports taken as shocks to exports of goods only.

3 Countries with credit ratings similar to those of the FCL countries typically do not experience simultaneous shocks

in key balance of payments categories associated with the 25th

percentile of past shocks.

4 For countries with no floating exchange rate weights are 30/15/10/10 for short-term debt at remaining maturity,

other portfolio liabilities, broad money, and exports of goods and services, respectively.




that for prudential purposes countries’ reserve coverage should be in the region of 100–150 percent

of the risk weighted liabilities.

Table I.1. Historical Shocks to Emerging Market Economies

(Global crisis in 1991, 2001, and 2009)

Source: IMF Staff Calculations

The impact of simultaneous shocks on reserves and reserve coverage was calculated for members

with FCLs, (Colombia, Mexico, and Poland), PLLs (Morocco), and SBAs treated as precautionary by

the authorities (Romania). Simultaneous shocks were applied to data for 2012 on exports, FDI, short-

term debt, and amortization of medium and long term debt. Shocks create an external financing

shortfall, which could be fully or partially accommodated with reserves depending on how much the

currency and/or the domestic interest rate are allowed to adjust. The calculated RAM after the shock

incorporates the new lower export and debt numbers, which lower the denominator and increase

the measured RAM. Summary results are displayed in Table I.2.

Table I.2. Summary: External Financial Shortfall from Adverse Shocks and Reserve Adequacy

Metric, Members with Precautionary Arrangements

Source: IMF Staff Calculations

1/ Under the EFS row, reserves are drawn down to accommodate 100 percent of the assumed shocks. Under the

three other rows, reserves accommodate 90 percent, 80 percent, and 50 percent respectively of the assumed

shocks.

2/ Reserve adequacy metric after the EFS or part of it is accommodated through reserves.

Results indicate that at the 25th

percentile of shocks, it is unlikely that most members under

precautionary arrangements, particularly FCLs, would draw under the arrangement, unless they were

5 10 25

Percent change

Exports -18.6 -13.3 -3.8

FDI -84.4 -67.0 -45.3

Rollover Rates, in percent

Short Term Debt

Public 16.6 21.2 67.8

Private 65.4 75.8 86.6

Medium and Long Term Debt

Public 26.6 32.4 51.9

Private 0.0 12.2 58.2

Percentile

5 10 25 5 10 25

EFS -41.1 -33.8 -16.3 8.8 42.4 88.3

90 percent of EFS -37.0 -30.4 -14.7 24.6 51.5 95.4

80 percent of EFS -32.9 -27.0 -13.1 40.4 59.9 102.6

50 percent of EFS -20.6 -16.9 -8.2 76.5 93.6 124.1

External Financial

Shortfall (EFS) 1/

Shock at percentile Shock at percentile

Median External Financial Shortfall Median Reserve Adequacy Metric 2/

(billion of US dollars) (percent of international reserves)



to rely on reserves to fully accommodate the shocks. At the 10th

percentile of the kernel distribution,

however, the loss of reserves would be far larger, leaving the median reserve cover under the RAM

at just 42 and 94 percent, when reserves fully and partially (50 percent) accommodate the shock,

respectively. Here, drawing would be very likely under the former scenario (full accommodation) and

possible under the latter (accommodation at 50 percent). At the 5th

percentile of shocks, the

situation would be worse and drawing more likely for all members with precautionary arrangements,

although it is debatable how relevant such an extreme shock assumption would be, particularly for

FCL-qualifiers.

Other Considerations

The exercise described provides an additional element for evaluating potential drawings under

precautionary arrangements. The results, however, are merely illustrative; they are constrained by

the nature of the statistical exercise and the characteristics of the database used.

It assumes univariate probability distributions, which may not capture aspects that help countries to

better accommodate external shocks, i.e., not all countries are affected and respond equally to

shocks. For instance, country differences in the degree of development of financial markets and

integration to the global economy affects the way global shocks are transmitted into the domestic

economies; furthermore, policy preferences could also affect the policy response regarding the mix

of access under precautionary arrangements, the use of reserves, exchange rate flexibility, and

interest rate adjustments to help cushion shocks.



Annex II. Market Risk and the Investment Mandate

The Fund is exposed to market risk on its investments. Market risk refers to the risk that the future

value of invested resources fluctuates because of changes in the value of underlying securities.

Resources in the Investment Account amounted to SDR 14,803 million as of October 31, 2013.

Investments held in the Fixed-Income (reserves portfolio) and Endowment subaccounts summed

SDR 10,359 million and SDR 4,445 million, respectively.

A. The Original Investment Mandate

The Executive Board established the Investment Account (IA) in April 2006.1 The investment

objective was to exceed the SDR interest rate, while minimizing the frequency and extent of negative

returns and underperformance over a 12-month investment horizon.2 The investment mandate

under the Rules and Regulations adopted under the restricted investment authority of the Fund at

that time, limits the portfolio to eligible obligations denominated in SDRs or in the currencies

included in the SDR basket. Eligible investments comprise domestic government bonds issued by

the governments of Fund members, international financial institutions, and certain national agencies.

The mandate established a 1–3 year benchmark of government bond indices weighted to reflect the

currency composition of the SDR basket. The investment mandate resulted in a portfolio of relatively

low volatility and a concentrated exposure.

B. The Expanded Investment Mandate

In January 2013, the Executive Board adopted new Rules and Regulations for the IA to implement

the expanded investment authority of the Fund under the Fifth Amendment to the Articles of

Agreement, which became effective in February 2011.3 The new Rules and Regulations provide for

the establishment of three sub-accounts within the Investment Account: the Fixed-Income, the

Endowment, and the Temporary Windfall Profits subaccounts, each of which has its own investment

objective and specific management provisions. The Temporary Windfall Profit Subaccount was

terminated in October 2013 following the transfer of its resources to fund the distribution of

amounts in the general reserve attributable to remaining windfall gold sales profits as part of the

strategy to boost the capacity of the PRGT.

1 The Fund’s Articles of Agreement authorize the establishment of an Investment Account (IA) and specify the

investment mandate in Article XII, Section (6)(f)(i) and (iii) of the Fund’s Articles of Agreement, respectively. The

mandate is implemented through a set of Rules and Regulations for managing the IA adopted by the Executive

Board. See Establishment of the Investment Account (4/17/06),

http://www.imf.org/external/np/pp/eng/2006/041406i.pdf.

2 The working expectation, a return of 50 basis points over the SDR interest rate (the implied cost of funds), is the

long-term premium between the SDR interest rate and the SDR-weighted 1–3 year government bonds. See the

discussion on the income outlook in Review of the Fund’s Income Position for FY 2013 and FY 2014 (4/30/13),

http://www.imf.org/external/np/pp/eng/2013/043013a.pdf.

3 See IMF Approves New Rules and Regulations for Investment Account, PR No. 13/37, February 4, 2013.

http://www.imf.org/external/np/pp/eng/2006/041406i.pdf




Pending a review of the investment strategy for the assets of the Fixed-Income Subaccount,

the investment mandate under the new Rules and Regulations for this subaccount is the

same as that under the 2006 Rules and Regulations. The investment objective is to produce

returns in excess of the 3-month SDR interest rate over time, while minimizing the frequency

and extent of negative returns and underperformance over a 12-month investment horizon.4

Assets in this subaccount, which correspond to the Fund’s general and special reserves that

are counted towards precautionary balances, should be managed against a 1–3 year

government bond benchmark weighted to reflect the currency composition of the SDR

basket. Its assets may be invested in marketable obligations of IMF members and

international financial institutions that are denominated either in SDR or in currencies

included in the SDR basket. Hedging is prohibited, including the use of derivative

instruments, short selling, or any form of financial leverage.

The Endowment Subaccount, funded with assets attributed to profits equivalent to US$850

per fine ounce from limited gold sales, has the investment objective of achieving a real U.S.

dollar return of 3 percent a year over the long term. Its assets should be invested in a

conservative, globally diversified portfolio consisting of fixed income assets and a limited

portion of equities and real estate investment trusts. Short selling and any form of financial

leverage, as well as direct investments in gold are not permitted; the use of derivative

instruments is allowed for hedging specific exchange rate risk on fixed income instruments

and for benchmark replication; currency hedging is not permitted for other assets in the

passively-managed portion of the portfolio; for the actively-managed portion of the

portfolio currency hedging is permitted, but not required.

No less than 90 percent of the assets will be passively managed by external managers, and no more

than 10 percent of assets could be managed actively also by external managers, with an initial cap of

5 percent. The investment of the passively-managed portfolio will be phased over a three-year

period expected to start in early 2014, in equal quarterly installments of about SDR 370 million.

During the phasing period, assets not managed externally should be invested following the

guidelines for the Fixed-Income subaccount. A further consultation with the Executive Board on the

actively managed tranche of the endowment is expected in the spring of 2014.

C. Assessment

The estimated potential losses for the IA portfolio, in each of its subaccounts, are currently small.

With the phasing of the Endowment subaccount’s assets to private managers, which is expected to

last about three years once started, the risk profile of the investment account portfolio as a whole

will increase, with potential losses increasing gradually as the phasing of assets progresses. As noted

4 Going forward, under an expanded investment authority and the Fund’s new income model, expectations are for

the subaccount to gradually exceed over time the SDR return by 100 basis points by FY 2017 versus the current 50

basis point target (see Consolidated Medium-Term Income and Expenditure Framework (4/30/13),





in previous papers, endowment-type portfolios differ from reserve portfolios: they typically have a

much longer investment horizon (the endowment is intended to be perpetual) and can afford a

greater variability of returns from year to year. This implies that the endowment can, and probably

will, incur periods of losses, sometimes over consecutive years, but over time should preserve its

capital and generate returns in real terms. With respect to the Fixed Income subaccount, as

government bonds in the markets of the SDR basket are close to their historical lows, and those

within the 1–3 year range are near the zero bound, the probability of losses should rates begin to

normalize has increased, but the scale of losses will be relatively limited given the short duration of

these assets.

Interest rate risk

The interest rate risk in the Fixed-Income Subaccount is mitigated by limiting the duration of the

portfolio to a weighted average of 1–3 years. An instantaneous 1 percentage point increase in

market interest would result in a loss of about SDR 200 million, or approximately 1.9 percent of the

portfolio. A 2 percentage point increase would double this loss. The Endowment Subaccount

currently holds fixed-term deposits on which the interest risk is limited.

Exchange rate risk

The portfolio exposure to exchange rate risk is currently negligible but will increase once the

Endowment Subaccount is fully invested. The Fixed Income portfolio is currently managed by

investing in financial instruments denominated in SDRs or in SDR basket currencies with relative

amounts of each currency matching its weight in the SDR basket. In addition, the portfolio is

regularly rebalanced to match the currency weights in the SDR basket. The net effect on the

investment portfolio of a 10 percent increase (devaluation) in the market exchange rates of the

basket currencies against the SDR would be a loss of SDR 0.4 million, SDR 0.09 million, and SDR 0.16

million for the variation against the euro, Japanese yen, and pound sterling, respectively. The net

effect of 10 percent decrease (appreciation) in the market exchange rate of the basket currencies

against the SDR would be a gain of SDR 0.4 million, SDR 0.09 million, and SDR 0.16 million, for the

variation in the euro, Japanese yen, and pound sterling, respectively.

The Endowment Subaccount, once fully invested, is expected to be subject to moderate risks,

particularly over the longer term. Whereas the SDR is the Fund’s unit of account, the US dollar will

be the Endowment Subaccount’s base currency. US dollar-denominated assets are expected to

account for about 40 percent of the portfolio, with almost two thirds of the portfolio exposed to

foreign exchange rate risks vis-à-vis the base currency. The currency hedging alternatives under the

expanded mandate are expected to remove a significant source of short-term portfolio volatility in



the base currency. Some of this volatility would, however, appear in the SDR denominated returns

recorded in the Fund’s financial statements.

Liquidity Risk

Liquidity risk on investments is limited by investing a portion of the portfolios in readily marketable

short- and medium-term financial instruments.

It is expected that liquidity risks will continue to be limited once the expanded investment mandate

is fully implemented, including the completion of phasing of assets under the Endowment

subaccount to private managers. While the endowment portfolio will include instruments that are

less liquid, such as emerging market bonds and equities and REITs, particularly under a tail event

scenario, the large share of developed market sovereign bonds (40 percent) and publicly-traded

equities (25 percent) will limit the liquidity risk of the overall portfolio.

Market Risk under Fully Implemented Mandate for the Endowment Subaccount

For the Endowment Subaccount, market risks would change once assets are phased into the Board-

endorsed strategic asset allocation. The phasing period is expected to take approximately three

years once it starts in early 2014. Once fully implemented, the endowment will be invested in a

greater range of asset classes and therefore will have greater market and credit risk although

mitigated somewhat by diversification of the portfolio. It will also be exposed to partial currency risk

(about one third of the portfolio will be hedged back to U.S. dollars), and to residual counterparty

risk, the latter mainly arising from the hedging of currency exposures through FX forwards and other

derivatives. These new risks will be controlled and mitigated primarily through key investment

decisions under the new Rules and Regulations, including the approved SAA, deviation bands

around target allocations, and eligible asset classes, rebalancing requirements, and minimum credit

thresholds. The controls embedded in the Rules and Regulations are supplemented by additional

measures taken by the newly establish Investment Oversight Committee. Finally, legal risk (the risk

arising from contractual obligations) is given specific attention in light of the broader range of assets

and countries in which the endowment will be invested, and to ensure compliance with the Board’s

guidance to avoid perceived or actual conflicts of interest.

As the endowment is not yet invested, accounting for financial risk is not yet feasible. Illustrative

historical and model-based measures on broad benchmark indices were used in past papers to

inform and guide the Executive Board in finalizing a strategic asset allocation. Such results indicated

an expected standard deviation of returns of about 8-9 percent, depending on the horizon. This is

significantly more than for funds invested in the short duration Fixed Income subaccount. Assessing

potential losses on the endowment was carried out in several ways. Simulated returns showed that

VaR returns, once the endowment portfolio was fully invested, could range from -14.4 percent over

a one-year horizon to -7.4 percent over a three-year horizon, with a 99 percent confidence interval,

with losses decreasing with time as the portfolio gradually recovered. In SDR terms, this would have

implied a loss of SDR 634 million over a one-year horizon and SDR 324 million over a three-year



horizon. In addition to portfolio simulations, the strategy was tested against past large market

corrections. Using as reference large equity and bond market corrections during 1970 – 2011, there

would have been two episodes where the endowment value would have dropped by more than

20 percent in real terms (peak to trough): in the early part of the 1970s, where both bonds and

equities endured losses, and during the recent global financial crisis, where losses would have been

about 25 percent. In both cases, a strong recovery would have followed.

Overall, market risks from the IA portfolio continue to be currently limited, with modest estimated

potential losses over the near term. Accordingly, it does not appear warranted for the framework for

assessing precautionary balances to make explicit provision for market risks or for the Fund to set

aside explicit amounts to address market risks.



Annex III. Burden Sharing Capacity, Credit Scenario Analysis and Stress Testing of the Fund’s Balance Sheet

Illustrations of burden sharing capacity and precautionary balances under alternative credit

scenarios and stress tests are employed to help guide the assessment of reserve adequacy. Section

A discusses the determinants of burden sharing capacity and highlights its current low capacity. In

section B, illustrative scenarios compare the target for precautionary balances to an average large

borrower under two different levels of peak credit outstanding—baseline and adverse scenarios.

Section C introduces stress tests that illustrate the possible ramifications for precautionary balances

and net income under a hypothetical situation where a member was unable to meet its obligations

to the Fund on a timely basis.

A. Burden Sharing Capacity

Background on burden-sharing of deferred charges

The burden-sharing mechanism was established in 1986 to compensate the Fund for any unpaid

charges by members in arrears (“deferred charges”), and in so doing, to offset the impact of unpaid

charges on Fund income. This has proven essential to protecting the Fund’s income position and to

complying with International Financial Reporting Standards with respect to the valuation of assets

on the Fund’s financial statements (see Boxes 2 and 3). The Fund’s creditor and debtor members

contribute equally to covering the amount of unpaid charges, which is achieved through increases in

the rate of charge paid by debtor members and reductions in the rate of remuneration to creditor

members.1

Limits on the capacity of the mechanism

The total capacity of the burden sharing mechanism to cover unpaid charges is the sum of the

maximum feasible reduction in remuneration expenses and the maximum feasible increase in

income from charges:

Article V, Section 9 (a) of the Fund’s Articles of Agreement states that the rate of remuneration

shall be no less than four-fifths (80 percent) of the SDR interest rate, limiting the maximum

reduction in remuneration expenses to:2

0.2 * SDR Interest Rate * Remunerated Reserve Tranche Positions

1 These adjustments are currently set to match charges in arrears but could also include the possible accumulation of

precautionary balances in the SCA-1.

2 Decision No. 12189-(00/45) (April 28, 2000) sets the current floor for remuneration at 85% of the SDR interest rate.

Changes in rate of remuneration require a Board decision with a seventy percent majority of the total voting power.



In the absence of arrears, the maximum burden sharing capacity would simply be twice the above

amount, because debtors and creditors generally contribute equally. However, the debtor base

contributing to burden sharing and thus the capacity of the mechanism declines in the event of

arrears.

Overall, the burden-sharing capacity depends on the following factors:

• Outstanding credit: as credit rises, the base for higher charges increases. Where such increase

in credit is financed fully from quota resources, reserve tranche positions broadly move in

tandem with credit fluctuations, increasing burden sharing capacity.

• Borrowing by the Fund: where Fund credit is funded with borrowed resources, the resulting

creditor positions (NAB and bilateral loan or note purchase agreements) do not increase

burden sharing capacity, as no burden sharing adjustment is made to the interest paid to

creditors on borrowed resources. As a result, use of borrowed resources reduces burden

sharing capacity relative to credit outstanding.

• SDR interest rate: at a higher nominal SDR interest rate, the rate of remuneration can be

reduced by a larger amount in terms of basis points, increasing burden-sharing capacity in

nominal terms.

• Share of credit in arrears: as noted, a higher share of credit in arrears shrinks the base of

debtors who make burden sharing contributions, thus reducing the burden sharing capacity.

Given the composition of Fund charges, the low SDR interest rate exacerbates the limitations

of burden sharing capacity. Since the burden sharing capacity is a function of the SDR interest rate

while unpaid charges are a functions of the SDR interest rate as well as the basic margin and, in a

number of cases, surcharges which are not directly linked to the SDR interest rate, burden sharing

capacity falls more rapidly than unpaid charges as the SDR interest rate declines (see Figure III.1).

At the moment burden sharing capacity is severely constrained. Specifically, using recent SDR

interest rates of under 10 basis points, and remunerated reserve tranche positions of SDR 45 billion,

the total burden sharing capacity is currently about SDR 13 million a year and the residual capacity

after taking into account deferred charges by Sudan and Somalia is about SDR 10 million. This

capacity, which represents less than 1 percent of the Fund’s estimated annual lending income, is a

small fraction of the burden sharing capacity that applied at the time of previous peak lending

period. For example, the capacity of the burden sharing mechanism stood at around one fifth of

annual lending income in 2003 and around one third of annual lending income in 1998 (the

previous two lending peaks).

Burden sharing capacity may increase over the medium term, but the timing of any such

increase is uncertain. SDR interest rates currently stand near historic lows of less than 0.1 percent,

and some reversion to the historical average of more than 2 percent since 2000 should be expected



over the medium term. The doubling of quotas under the 14th

General Review would also ease the

current reliance on borrowings, increasing burden sharing capacity. However, the timing of any

increase in burden sharing capacity remains uncertain. This situation further underlines the

importance of maintaining an adequate level of precautionary balances.

Figure III.1. Burden Sharing Capacity (BSC) in Percent of Total Charges

at Different Levels of the SDR Interest Rate 1/


1/ The floor for remuneration is 80 percent of the SDR interest rate. Assuming that remunerated reserve tranche

positions equal credit outstanding, i.e., no borrowing by the Fund.

2/ A basic margin for the rate of charge of 100 basis points, abstracting from surcharges.

3/ A basic margin of 100 basis points, plus average surcharges of about 150 basis points for the credit outstanding

(based on FY2013-FY2015 projected average).

B. Credit Scenario Analysis

The credit scenarios provide a simple stock illustration of the size of precautionary balances relative

to various levels of credit outstanding and implied size of the Fund’s average large exposure (Table

IIII.1).

Under the baseline scenario credit peaks at around SDR 90 billion in FY2013 (line A), implying

that the current precautionary balances target of SDR 20 billion would represent about

0%

5%

10%

15%

20%

25%

30%

0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25% 2.50% 2.75% 3.00% 3.25% 3.50%

BS

C (in

perc

ent

of

tota

l charg

es d

ue)

SDR Interest Rate

SDR Interest Rate as of end-December 2013

(0.07 percent)

Maximum BSC, Basic Margin Only 2/

Maximum BSC,Including Surcharges 3/



22 percent of credit outstanding, at the lower end of the reserve coverage range suggested by

the framework (line B), but would more than cover the average large exposure (line D). This

assumes that precautionary arrangements are not drawn on.

In an adverse scenario, global economic and financial conditions are assumed to deteriorate

further, leading to significant additional demand for Fund credit, including drawing on

precautionary arrangements. In this scenario, credit outstanding is projected to peak at SDR 280

billion, much higher than the baseline level but substantially short of recent tail-risk estimates.

Here, the current target of precautionary balances of SDR 20 billion would amount to only

7 percent of credit (line B) and be considerably smaller than the estimated average exposure of

the largest borrowers (line D).

Table III.1. Illustrative Scenarios: Implications for Precautionary Balances Coverage 1/


1/ The baseline scenario is consistent with current peak credit as in Table 4. Credit outstanding under the adverse scenario is

based on the additional financing need in a tail risk scenario outlined in the recent NAB activation plus current credit

outstanding, which shocks MT debt rollover rates, FDI and equity flows and includes deposit flight. However, this financing need

is reduced by half as the scenario is not intended to reflect a severe tail risk event and current credit outstanding is added.

2/ Based on illustrative assumptions for the average size of the five largest borrowers. As of end-2013, the actual average credit

outstanding and undrawn balances for the five largest non-precautionary arrangements was slightly over SDR 16 billion.

C. Stress Testing the Fund’s Balance Sheet

The stress tests below provide an illustration of the possible dynamic effects on the Fund’s income

and precautionary balances of charges in arrears and a reduction in the carrying value of the asset

associated with the charges in arrears across periods. The logic followed here is that charges in

arrears could create an income loss which would first be absorbed by burden sharing (see Boxes 2

Scenario A Scenario B

"Baseline" "Adverse"

Implications for reserve coverage at various levels of precautionary balances

A. Peak credit outstanding (SDR billions) 90 280

B. Precautionary balances as percent of credit outstanding,

assuming precautionary balances of:

SDR 15 billion15 billion 17 5

SDR 20 billion 22 7

SDR 25 billion 28 9

C. Average large exposure (SDR billion) 2/ 16 50

D. Precautionary balances as percent of average large exposure,

assuming precautionary balances of:

SDR 15 billion 94 30





and 3). If these losses exceeded burden sharing capacity, an assessment of the carrying value of the

asset associated with the arrears would need to be made. Any income and stock impairment loss net

of burden sharing that resulted from this assessment would need to be absorbed by net income in

the current period. Depending on the residual level of net income, precautionary balances or the

pace of their accumulation could fall. It should be emphasized that assessments of the carrying

value of assets would require considerable judgment, taking into account the full range of

circumstances, including other aspects of the Fund’s multilayered financial risk management

framework and the circumstances in which arrears had occur.

Methodology and assumptions: The projections in the medium term framework3 provide the

foundation for the stress tests. For illustrative purposes, the amount of principal giving rise to

charges in arrears is assumed to be the average of large borrowers from the baseline credit scenario.

In the periods under stress, income falls vis-à-vis the medium-term projections due to a decline in

income from the basic margin and surcharges as credit in good standing falls. Income from the

service charge and commitment fee is assumed to be unchanged throughout. There is also an

additional effect on net income as slower accumulation of precautionary balances leads to lower

investment income vis-à-vis the medium term projection in the following period. As noted in section

A, maximum burden sharing capacity also declines as credit in good standing declines.

For purely illustrative purposes, the reduction in the carrying value of the asset, should income

losses exceed burden sharing capacity, is hypothetically assumed at 25 percent (other assumptions

are also presented). It is important to note that the current accounting standard does not provide a

specific methodology for assessing impairment losses as the difference between the asset’s carrying

amount and the present value of estimated future cash flows using the effective interest rate.

The stress tests: Table III.2 illustrates the effect on the Fund’s income from charges in arrears

associated with principal of SDR 16.5 billion starting in FY 2015. The burden sharing capacity is

exceeded and the carrying value of the asset is assumed to fall 25 percent creating net negative

income in that period, which reduces precautionary balances. The continuing effects on net income

via lending and investment income are carried forward through FY 2019 resulting in 30 percent

lower stock of precautionary balances relative to the medium term projections. Under these

assumptions, the stock of precautionary balances does not reach its FY 2014, pre-stress, level until

FY 2018. Importantly, however, precautionary balances would remain over SDR 10 billion, providing

a sizeable buffer to handle any additional financial shocks.

3 See The Consolidated Medium-Term Income and Expenditure Framework (4/30/13),





Table III.2. Dynamic Stress Test of IMF Portfolio: Illustrative Cash Flow

and Stock Ramifications FY 2014 – FY 2019 1/

(billions of SDRs)

Source: Finance Department and staff calculations.

1/ Based on current medium-term assumptions. Principal in arrears is set to the average large borrower of SDR 16.5 billion,

calculated as the average peak exposure to the five largest borrowers. The effect of principal and charges in arrears on

precautionary balances works through lending income (margin and surcharges), burden sharing capacity, investment income,

and remuneration on principal in arrears. Further, when the loss of income exceeds the burden sharing capacity, a one-time

reduction in the carrying value of the assets in arrears is assumed at 25 percent for illustrative purposes. Figures may not add up

due to rounding.

2/ As implied by forecasts in The Consolidated Medium-Term Income and Expenditure Framework (4/30/13).

3/ Implied by calculated principal giving rise to charges in arrears and forecasted investment income, commitment fees, service

fee income, and expenses as in The Consolidated Medium-Term Income and Expenditure Framework (4/30/13), and including

shortfalls in SDR interest income due to charges in arrears. Income from surcharges and the basic margin are variable depending

on the calculated amount of credit in good standing, based on the current margin and implied surcharge rate in The

Consolidated Medium-Term Income and Expenditure Framework (4/30/13).

4/Forecast SDR interest rate as in The Consolidated Medium-Term Income and Expenditure Framework (4/30/13) and the

remunerated reserve tranche position implied by the calculated principal in arrears and borrowing assumptions.

Table III.3 illustrates the effects on net income and precautionary balances of different assumptions

for the reduction in carrying value, the stock of principal in arrears, and interest rates over a two-

year horizon. An assumed reduction in the carrying value of the asset of 15 percent, rather than

25 percent, would result in negative net income in the year of the shock and reduce the trend level

of precautionary balances by SDR 3-4 billion. In the event of a fifty percent reduction in carrying

value, the impact on net income would be very large and precautionary balances would decline to

half their current level. The immediate impact would be broadly similar in the event of a larger

affected principal giving rise to charges in arrears (assumed hypothetically to be double the size of

the average large borrower). In the latter case, precautionary balances would recover less quickly

because net income continues to be constrained by higher charges in arrears. Doubling the SDR

interest rate in FY 2015-FY 2016 compared to the medium-term framework has only a marginally

worse affect on net income versus the 25 percent reduction scenario.

FY14 FY15 FY16 FY17 FY18 FY19

Net Income under current medium term projections 2/ 1.62 2.07 1.75 1.72 1.61 1.40

Net income after charges in arrears 3/ 1.62 1.64 1.25 1.20 1.06 0.84 plus - - - - - -

Maximum burden sharing 4/ 0.01 0.02 0.05 0.09 0.12 0.15 equals - - - - - -

Total net income on cash flow basis 1.64 1.64 1.23 1.16 0.97 0.70

minus

Illustrative reduction in carrying value of asset - 4.13 - - - -

equals - - - - - -

Total net income after accounting for stock reduction 1.64 (2.49) 1.23 1.16 0.97 0.70

resulting - - - - - -

Precautionary Balances 13.16 10.61 11.70 12.64 13.51 14.11

Memorandum Items:

Precautionary balances under medium term projections 2/ 13.2 15.2 16.8 18.3 19.8 21.1

SDR interest rate 2/ 0.10 0.20 0.60 1.00 1.50 2.00

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Stressed Periods

Table III.3. Dynamic, Comparative Stress Testing: Illustrative Cash Flow

and Stock Ramifications FY 2015 – FY 2016 1/

(In billions of SDR)

Source: Finance Department and staff calculations.

1/ Based on current medium-term assumptions. Principal in arrears is set to the average large borrower of SDR 16.5 billion, calculated as the average peak exposure to the five

largest borrowers. The effect of principal and charges in arrears on precautionary balances works through lending income (margin and surcharges), burden sharing capacity,

investment income, and remuneration on principal in arrears. Further, when the loss of income exceeds the burden sharing capacity, a one-time reduction in the carrying value

of the assets in arrears is assumed at varying levels. Figures may not add up due to rounding.

2/ See Consolidated Medium-Term Income and Expenditure Framework (4/30/13).

3/ Implied by calculated principal in arrears and forecasted investment income, commitment fees, service fee income, and expenses as in The Consolidated Medium-Term

Income and Expenditure Framework (4/30/13). Income from surcharges and the basic margin are variable depending on the calculated amount of credit in good standing,

based on the current margin and implied surcharge rate in The Consolidated Medium-Term Income and Expenditure Framework (4/30/13).

4/ Forecasted SDR interest rate, and the remunerated reserve tranche position implied by the calculated principal in arrears and borrowing assumptions.

5/ Implied by projected SDR interest rate as in Consolidated Medium-Term Income and Expenditure Framework (4/30/13) and illustrated principal in arrears.

6/ SDR 33 billion instead of SDR 16.5 billion and assuming 25% stock reduction.

7/ SDR interest rate in FY15 and FY16 increases to 40 bps and 120 bps from 20 bps and 60 bps, respectively.

FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16

Net Income under current medium term projections 2/ 2.07 1.75 2.07 1.75 2.07 1.75 2.07 1.75 2.07 1.75

Net income after charges in arrears 3/ 1.64 1.27 1.64 1.25 1.64 1.20 1.29 0.83 1.64 1.25 plus

Remuneration gap due to non-collection of SDR interest on

principal arrears 5/ 0.02 0.07 0.02 0.07 0.02 0.07 0.05 0.13 0.04 0.13 equals - - - - - - - - - -

Total net income on cash flow basis 1.64 1.25 1.64 1.23 1.64 1.18 1.26 0.75 1.63 1.21

minus

Illustrative reduction in carrying value of asset 2.48 - 4.13 - 8.26 - 8.26 - 4.13 - equals

Total net income after accounting for stock reduction (0.84) 1.25 (2.49) 1.23 (6.62) 1.18 (6.99) 0.75 (2.50) 1.21 resulting

Precautionary Balances 12.3 13.4 10.6 11.7 6.5 7.5 6.1 6.7 10.6 11.7

Principal in arrears at

twice avg large

borrower 6/

Double SDR interest

rate assumptions 7/

Stock value

reduction at 15%

Stock value

reduction at 50%

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